The Bank of England’s decisions on 7th November to leave the Bank Rate and stock of Quantitative Easing (QE) unchanged came as no surprise. The Bank Rate freeze was in line with the Bank’s policy of ‘forward guidance’ (its stated position on the likely path for interest rates) and both announcements were exactly what the financial markets expected. This policy of ‘no change’ by Britain’s monetary authorities contrasts with the European Central Bank (ECB) decision, announced shortly afterward, to cut its key discount rate from ½ per cent to ¼ per cent. Recent UK economic indicators have been doing better while there is growing concern in Continental Europe that the Eurozone may be heading for deflation, with annual consumer price (CPI) inflation down to 0.7% in October compared with the 2.7% recorded in the UK in September.*
However we must not forget that one unintended side effect of the ‘big government’ policies implemented in Britain, the US and many peripheral Eurozone economies since 2000 has been to reduce sharply aggregate supply – the total amount of goods and services that the economy can produce at full employment. As a result the danger now is that a lax monetary policy is more likely to produce stagflation than the healthy low inflation growth desirable in Britain and other mature industrial nations.
Monetary policy has at least three separate elements: Bank Rate setting; funding policy, and regulatory policy. All three must point in the same direction if policy is to be effective. This has not been the case in Britain in recent years: an unduly low Bank Rate and an expansionary funding policy (i.e., QE) were tugging in the opposite direction to the restrictive effects of over-regulation. However, there has recently been a marked acceleration in the annual growth rate in the Bank of England’s ‘Divisia money’ measure, even if this has yet to be fully reflected in the more important M4ex broad money definition. The annual growth in Divisia money has accelerated from a low point of minus 0.5 per cent in February 2012 to plus 9.3 per cent in September 2013, or from 2.1 per cent in January 2012 to 9.5 per cent in September 2013 if the deposits of ‘other financial corporations’ are excluded. This seems a noteworthy – albeit little commented upon – development, which has coincided with the rebound in UK activity.
An important reason for wanting to raise Bank Rate in the near future is to warn potential house buyers in a market which remains overvalued that rates are abnormal and should not be expected to stay so low for long. The ratio of house prices to permanent income is still roughly one standard deviation (or some 16½ per cent) above its long-run mean. There is a risk that innocent young people are being sucked into the property market at over-inflated values by schemes such as Help to Buy. Such naïve first time buyers could potentially lose a third of their capital if house prices reverted to one standard deviation below their mean ratio when (or if) interest rates were normalised. Economic agents need to be made aware that borrowing costs will inevitably revert to some long-term norm closer to 5 per cent than their current ½ per cent, even if this may be politically inconvenient for a government that faces a general election in little over one-and-a-half years’ time.
The requirement now is to start the process of normalising Bank Rate in a series of small ¼ per cent hikes, possibly carried out at two month intervals until a figure of around 2 to 2 ½ per cent is reached, after which a pause for reflection may be appropriate. Some might object that this would pull the rug from under the recovery. However, the simulations on the Beacon Economic Forecasting (BEF) model presented in the October 2013 Shadow Monetary Policy Committee report from the Institute of Economic Affairs suggest small changes to Bank Rate make little discernible difference either way as far as the wider economy was concerned. QE was needed during the period of financial panic but should now be unwound gradually by not undertaking commensurate new purchases as the Bank’s existing holdings of gilts gradually matured. There is little case for aggressive sales of the existing £375bn stock of QE while the annual growth of M4ex broad money remains around the relatively subdued 4.3 per cent recorded in the year to September and the sterling index stays around its present 83 (January 2005 = 100). However, it would be necessary to be far more aggressive if monetary growth accelerated further into the 7½ to 10 per cent range or the external value of the pound fell significantly. This is because the last thing that the UK economy needs is a fourth unsustainable credit boom to add to the excesses of the early 1970s Heath-Barber boom, the late 1980s Lawson boom, and the Brown boom of the earlier 2000s.
* It is worth noting that some leading indicators – such as those compiled by the US Conference Board – suggest that Eurozone activity is picking up, while recent reductions in the price of oil may have had more to do with the reduced Continental rate of price increase than weakening activity. In which case, the Eurozone rate cut may not have been entirely appropriate.
*David B Smith is Visiting Professor, Derby Business School, and Chairman of the IEA’s Shadow Monetary Policy Committee. He is author of ‘Financial Regulation and the Wider Economy: Unintended Consequences’ in Politeia’s The Financial Services and the UK Economy: The Danger of Over-Regulation.