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How will policymakers know when the time is right to raise interest rates...?
AND SO the Bank of England's Monetary Policy Committee has brought its programme of asset purchases to a halt again, writes former MPC member Andrew Sentance.
This partly reflects better news on the UK economy over the last few months. But it may also indicate that the MPC is beginning to doubt the effectiveness of continuing to provide further monetary stimulus through Quantitative Easing (QE).
In 2009, cuts in interest rates and the first round of QE helped stabilise the UK economy in the immediate aftermath of the financial crisis, and provided the basis for a slow recovery. Growth has been disappointing – but this may not be something that can be addressed by monetary policy.
In my view, relatively slow growth is part of the "new normal" for the UK and other western economies and reflects the departure from the world of easy money, cheap imports and strong confidence which prevailed before the financial crisis. That world cannot be recreated simply by providing more and more demand stimulus. The major western economies including the UK face a prolonged process of economic adjustment, and this is not an environment in which we should expect growth to return to the rates we were accustomed to before 2007.
So monetary policy is on hold for now. But at some point the MPC needs to plan for an exit from the very stimulatory monetary policies that have been pursued in recent years. The current official Bank Rate of 0.5% is not only low by recent standards. It is the lowest in the history of the Bank of England and much lower than the 2 percent rate which prevailed in the Great Depression of the 1930s.
The MPC strategy so far has been to wait until the "time is ripe" for interest rates to rise – a combination of strong growth and an inflationary threat which justifies rising interest rates. But in the current "new normal" world it will be very difficult to judge the right economic conditions to start raising interest rates. The recent growth and inflation performance of the UK economy has been very different to the experience before the financial crisis. There is a risk that the time never appears to be right to raise interest rates and unwind the bond purchases made under Quantitative Easing.
This scenario raises a number of concerns. First, a rate of interest which compensates savers for inflation and provides a reasonable return in real terms is one of the mechanisms which ensures that investment funds are deployed efficiently to support the long-term growth of the economy. There is therefore a serious risk that the growth potential of the UK economy will be harmed by a very prolonged period of exceptionally low interest rates.
Second, the longer we persist in a world of very low interest rates, the greater will be the shock to the private sector when interest rates do start to rise. Businesses and households are likely to be able to plan for and adjust to a gradual approach to raising interest rates over a number of years.
A third concern is the impact on the credibility of the Bank of England and perceptions of its independence. The Bank has so far been reluctant to raise interest rates, even though inflation has been almost continually above the 2 percent target since 2007/8. If this situation persists – as it could well do – the credibility of the Bank's commitment to stable prices will increasingly be questioned. Similarly, if the £375bn of bond purchases made by the Bank through QE are not eventually unwound, it may appear that the Bank has printed money simply to finance the government's deficit – a policy which has created inflation and threatened the financial stability of economies in the past.
A better strategy would be for the MPC to plan for a gradual rise in interest rates, accompanied by a gradual unwinding of its QE asset purchases over the next few years. It would be unrealistic and undesirable for interest rates to go back quickly to the rates seen before the financial crisis. But a gradual rise to around 2-3% over the next 2-3 years would help the economy to acclimatise to a more normal level of interest rates – allowing firms and households to plan accordingly. This would help avoid the twin risks of a very prolonged period of exceptionally low interest rates - which could be damaging for longer term growth - and a sharp lurch in monetary policy which derails the recovery.
Interest rate rises may not be on the agenda yet. But if the economy continues to grow next year and the recovery becomes more strongly established – as economic forecasts generally suggest - it will make sense for the MPC to start planning for an exit from the emergency monetary policies which have been in place since early 2009.
This blog summarises a longer article in the November 2012 Economic Outlook which is available on the PwC website and also contains updated forecasts for the UK economy.
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