Should the Bank of England raise interest rates?

Following on from the ECB decision to raise interest rates, debate continues as to whether or not the Bank of England should engage a process of interest rate normalization, in order address current above target inflation. A key argument against monetary policy tightening in the UK is that a low nominal interest rate and inflation in excess of the target are key elements in sustaining the negative real interest rates needed to revive private sector demand in an economy struggling to recover from post-crisis deleveraging in both the private and public sectors.

A couple of other questions feed into this important debate:

(1) Is the current UK inflation best viewed as macroeconomic failure that needs to be corrected, or as an efficient means to achieving economic adjustment given the shocks that have impacted the economy?

(2) Would a rise in interest rates be effective in combating the kind of inflation that the UK is now experiencing?

On (1), I think there are grounds for viewing the current inflation overshoot as a means to rebalancing the economy rather than an undesirable deviation from equilibrium. As argued in a previous post, a period in which inflation exceeds the target may be the most efficient route to the macroeconomic adjustment the UK needs to accomplish. The argument starts from the idea that effective demand for labour at each value of the consumer real wage appears to have fallen. Simply put, if the UK government is to transition from net spender to a (real terms) net saver, and if the cost of elevated real import prices is to be met, the real value of what firms offer to workers must fall. This is one element in the rebalancing of the UK economy and is reflected in the rapid squeeze in real take-home pay for households that is currently being observed. There are two ways to complete this transition: (i) a temporary bout of consumer price inflation in excess of the target; (ii) a period of declining money wages in the public and private sectors. The pay freeze in the public sector and the low wage growth in the private sector suggest that mechanism (ii) is being used to the maximum, given that declining money wages risk political and social opposition as well as many of the economic distortions associated with deflation. Consequently mechanism (i) needs to play a part in completing real wage adjustments. So long as the current round of inflation observed in the UK is not met with domestic real wage resistance -- and the data suggest this is not the case -- it is the optimal way to achieve the macroeconomic adjustment that the UK must make, and should not be grounds for a premature tightening of UK monetary policy.

In relation to (2), the question is whether a rise in domestic interest rates would be an effective tool in fighting inflation that is largely attributable to increases in consumption taxes (VAT) and rising import prices. Interest rate increases would provide an effective means of containing rampant domestic consumer spending and escalating wage settlements, but as noted above, these inflation drivers are subdued at present. So would a rising interest rate trajectory do anything to offset the current sources of UK inflation? One possibility is that by getting ahead of the game in the global interest rate cycle, the Bank of England could effect an appreciation of sterling that would stabilise the UK import price index in the face of rising international inflation. In effect, this would reverse the inflation contribution from the rapid pass-through from the depreciated exchange rate to import prices that has been observed in the last couple of years. This scenario seems plausible, though there are a couple of limiting factors. One is that UK importers may take advantage of a sterling appreciation in order to raise their profit margins rather than set lower sterling prices. A second is that, set against the outlook for weak GDP growth, any rise in interest rates will not be interpreted as the beginning of a sustained rise in returns to UK investments, and that as a result any sterling appreciation will be limited. The underlying causes of inflation would then be little affected, and higher interest rates would simply intensify cash flow pressures facing UK households and small businesses.

A second channel through which a rise in interest rates may help offset inflation pressures is its effects on firms' and retailers' margins. Increases in VAT and the price of imports need not translate into higher CPI inflation if the corporate sector is willing to absorb those costs and accept a lower profit share, rather than pass on the pain of higher prices to consumers. One argument that could then be brought into play is that domestic interest rate increases leave the household sector so weak, in the face of rising costs of debt service on mortgages and credit cards, that firms do not dare to raise consumer prices for fear of a demand collapse, and instead absorb some of the pain through sacrificing profits. Is this scenario likely to come to pass in the event that interest rates rise? A lot comes down to the extent to which firms can accept lower profit margins. My sense is that some large corporations have been quite profitable despite the events of recent years, in large part due to the extremely low cost of capital that they have enjoyed as a result of quantitative easing and flight-to-quality in financial markets. However, many smaller firms have not enjoyed these benefits and would not have scope to lower profits in order to slow inflation.

On balance, arguments related to question (2) suggest that rising interest rates would not automatically remedy rising inflation, so even if one takes the view that inflation should be top of policy-makers list of concerns, the case for a tightening of UK monetary policy is not overwhelming.