Why the Bank of England Must Change Course

Former MPC member Andrew Sentance on why it's time to end the squeeze of record low interest rates...

THIS MONTH marks the third anniversary of the Bank of England Monetary Policy Committee meeting at which I and my fellow MPC members unanimously agreed to cut interest rates to 0.5% and started the program of injecting money directly into the UK economy, known as Quantitative Easing (QE), writes former MPC member Andrew Sentance. 

Three years on, Bank Rate remains at 0.5%. And the Bank's money creation program was restarted last autumn after a pause of around eighteen months. By the beginning of May, the Bank's QE injections will have totaled £325bn – over 20% of GDP and equivalent to over £5,000 for every man, woman and child in the country.

In 2009, I was a supporter of QE and the need for exceptionally low interest rates. The minutes of the MPC meeting three years ago record how difficult the economic situation was at that time. The economy was rocking and reeling from the shockwaves of the financial crisis. Economic activity was falling sharply and unemployment was rising alarmingly. It was essential that the MPC took all necessary measures to stabilize the economy at that time.

The world is calmer now, and recovery is underway – even if it is uneven. The world economy started to pick up in the second half of 2009, when recovery also started here in the UK. Though growth has been disappointing recently, it has been sufficient to create around 600,000 extra jobs in the private sector since the trough of the recession in mid-2009.

But in 2009, I did not envisage that we would have persisted with such exceptionally low interest rates for so long. Nor did I expect that the MPC would embark on a second round of QE in late 2011. And I was not alone in these views. The expectation of financial markets in mid-2009, when the first round of QE was in full swing, was that official interest rates would be back up to 3-4% by now, not stuck at 0.5%. QE has reinforced the effect of these low interest rates – by depressing government bond yields and hence the whole structure of long-term interest rates in the economy.

In another important respect, the MPC's expectations in 2009 were also awry. The Bank of England's official remit is to set UK monetary policy to keep inflation on target at 2%. Three years ago, the forecasts suggested that the main problem we were likely to face was a prolonged period of very low inflation with a significant risk of deflation. As it has turned out, inflation has run persistently above the 2% target for over two years, peaking at over 5% late last year. Even in January, with the VAT rise dropping out of the annual rate, CPI inflation was 3.6%. With oil prices now picking up again, the current phase of above target inflation could persist through this year and into 2013.

This combination of low interest rates and high inflation has been particularly painful for savers. But all members of society have felt the squeeze from the prolonged period of above target inflation we have experienced since the financial crisis.

It is far from clear that an economy which has been suffering from persistent high inflation needs a policy which is designed to push up inflation further. Yet that is precisely what the MPC expects QE to achieve. The Committee believes it is forestalling a sharp fall in inflation and hence helping to keep inflation on target. But it has consistently underestimated inflationary pressures in previous forecasts, and is at serious risk of making the same mistake again.

At this month's meeting it would be most surprising if the Committee did anything other than continue with this policy. But I hope that when the May meeting comes round, the Committee will decide to bring its current QE program to an end.

The Bank of England – along with other Central Banks – faces the challenge of moving away from emergency policy settings which have been maintained since the depths of the financial crisis (see my article here). 

There may well be no easy time to embark on this process, given the world of disappointing growth and economic volatility which now appears to be the "new normal" for the UK and other western economies. But if we don't start the gradual shift away from emergency monetary policy settings soon, the MPC risks having to play catch-up in the future: pushing up interest rates sharply and triggering a large negative shock to business and consumer confidence.

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