Wednesday, 12 January 2011

It is time....

...for the monetary policy committee to finally raise interest rates.

Tomorrow, the committee begins its January meeting where it will decide if it will finally begin to tackle the growing inflationary momentum that is now building up within the UK economy.

Actually, the committee should never have cut rates down to almost zero in the first place. It only served to destabilize the economy, creating an atmosphere of panic and self-fulfilling expectations of a recession. It also created perverse incentives, and transferred huge amounts of income away from prudent savers to speculators and debtors. However, that is last year's debate. The important thing is this week's decision.

The UK economy would gain enormously if rates were increased. It would offer a powerful signal of a return to economic normality. This would create the basis for improved consumer expectations, sustained investment and economic growth.

A rate hike would break the dependency culture within the financial sector. Banks would have to restructure their operations without the oppressive public sector safety net. It would also encourage an increase in bank deposits, which would stabilise funding and reduce reliance on flighty wholesale financial flows.

There is, however, a more important reason for an immediate rate hike. The bank needs to prepare for the next crisis.

Whether we like the new world of deep public expenditure cuts or not, the coalition's austerity program has bought the UK economy some time. Financial markets believe that the programme is serious and therefore government bond rates remain comparatively low.

At the moment, financial markets are flying on the fumes of a fiscal consolidation. So far, the coalition has promised much but delivered very little. The deficit continues to be extremely large, tax revenues have not recovered, and expenditure is still rising.

Nevertheless, the coalition has gained the confidence of financial markets. This gives the bank a short window of opportunity. The coalition's credibility will allow the Bank to begin raising rates at a moderate pace, providing a powerful signal that it is ready to tackle inflation, and without strangling growth.

There is still a danger that the UK could face a perfect economic storm in the near future. Suppose the coalition's austerity program fails to reduce the deficit as quickly as planned. This will mean that the government will have to go to the bond market with a large funding requirement to cover an unexpectedly large deficit. If at the same time, inflation has the government could face a sudden change in market sentiment that could see bond rates increase sharply.

It is precisely these kinds of funding difficulties that have forced Greece, Ireland, and Portugal into extremely painful adjustments. Yet these adjustments were undertaken when inflation remained subdued. Imagine, for a moment the consequences for growth if the the Eurozone basket cases also had to raise rates in order to curb inflation?

If the Bank begins to raise rates now, it would put downward pressure on prices, and reduce the risk of this perfect storm. It would also re-establish a decree of control of monetary conditions; something the bank lost once it cut rates down to almost zero. This would also give it some room for maneuver should growth begin to slow.

The alternative - maintaining the current level of interest rates, would gain the bank nothing. True, it would offer commercial banks cheap financing, but it would continue the overwhelming pall of instability that now smothers the UK economy.

It is time to put an end to the financial crisis. It is time to increase the bank rate.


WF said...

You have me convinced. How big should the rate rise be? And where should they end up?

Anonymous said...

I see you have managed your normal level of well thought out analysis and incisive discourse Alice.

Anonymous said...

Sorry but interest rates are staying low. Won't happen, Alice.

London Estate Agent said...

I see rates were unchanged. Seems like the boe didn't read your blog.

Nationalist said...
This comment has been removed by the author.
Nationalist said...

What I meant to say is that it looks like the BOE/Govt intends to let our debts inflate away by keeping IRs too low for too long. The loss of our savings has probably been deemed a price worth paying.

Bill Quango MP said...

Thinking much the same thing. From the retail data it seems that prices are up 1%. There's a lot more to follow in Feb/March when the new stock hits the shelves. A 10% hike in materials, + the transportation costs and VAT hike.
Expect April will see a 1/4 rise.
May , another 1/4 or even 1/2.