Now Is Not the Time to Raise Interest Rates

Op-ed in the Financial Times

May 26, 2011

The UK's economic performance over the past year is no surprise. When you tighten fiscal policy significantly after a major financial crisis, both history and mainstream economics would tell you to expect what we have now: no growth in broad money or credit, persistently high interest spreads for small businesses and households, flat or contracting private consumption and retail sales, a dearth of construction and declining real wages-all only partially offset by some expansion in exports. In such a situation, you should expect little domestically generated inflation, and that is also just what the UK has.

The recent consumer price inflation rates above 4 per cent result from this year's value added tax increase and the recent energy price shock. Removing those factors, UK inflation has averaged 1.5 per cent over the past year- including any remaining effects of sterling's past decline. Of course, higher taxes and energy prices shrink British real incomes, but the monetary policy committee was right not to respond to them, and should not do so now.

Raising interest rates to offset VAT hikes is counter-productive because a VAT increase contracts nominal demand, while its measured price impact is one-time only. Energy prices are volatile and can reverse with no notice, as they just did. Setting monetary policy in response to short-term commodity price gyrations would only destabilize the UK economy and create greater uncertainty about future inflation.

These temporary factors are a distraction from the post-crisis dynamic of the UK economy-weak recovery, no wage pressures and, yes, declining headline inflation to come. The Bank's monetary easing to date, combined with the global stimulus of 2008-09 and an aggressive financial clean-up, put a floor under developments and kept core inflation above zero. But recovery from a financial crisis takes years. Tightening fiscal policy with no offset from additional monetary easing will strengthen the underlying disinflationary pressures-as in Japan in 1997, when VAT was raised without a monetary response.

This is why, in September 2010, I made public my forecast of below-target inflation by mid-2012 and began voting for additional quantitative easing. Since then, the UK economy has behaved pretty much as I expected. I never made any prediction for inflation in 2011, down or up, because the short-term fluctuations of inflation were irrelevant to my own policy decision.

Inflation targeting is like shooting clay pigeons, not throwing darts. To hit the target we must aim at where the clay is going to fly, not at a fixed board. We have to set policies now to hit the target in roughly two years' time. People urging rate rises today are playing the wrong game, would only miss the inflation target and maybe poke innocent bystanders in the eye. The transient upward push to UK headline inflation from VAT and energy will be outweighed by the more persistent downward forces of fiscal consolidation and household deleveraging-already evident in the core inflation measures, and in the past year's consumption and wage data.

Some maintain that even if my forecast for UK inflation is largely reasonable, the MPC should still raise rates to prevent a rise in long-term inflation expectations. This view assumes that the market will bet on a static darts game, despite clear evidence that investors, like the MPC, recognize the game is dynamic. Sterling and gilt investors placed bets in line with the forward-looking nature of the policy challenge and with the MPC majority's assessment of the economy. That is why long-term inflation expectations remain consistent with the target and why long-term interest rates-which the Bank does not control-remain low.

Those arguing tighter monetary policy is essential to the MPC's credibility must explain why long-term inflation expectations have remained anchored after months of headline inflation overshooting the target. Long-term rates and sterling stayed stable even when expectations for a first interest rate hike moved out to January. The logical explanation is that the markets' understanding of the economy and forecast for inflation are close to my own. The MPC must not raise rates out of unfounded fear of senseless expectations-which, if dominant, should have been apparent in markets by now.

The majority of the MPC is right to have held its nerve against calls for rate hikes. The fiscal contraction and household deleveraging will continue, as will household deleveraging, and wages will grow more slowly than productivity. Headline CPI inflation will decline towards the target, where core inflation already is. In fact, the MPC should go further. To meet the inflation target in two years' time, the MPC must pursue more QE.