Raise interest rates gradually or risk a much sharper swing of the pendulum
FOR A given level of inflation, an economy has an “equilibrium” real interest rate. For around 125 years, it has been understood that trying to use policy to manipulate actual interest rates below the equilibrium rate for any sustained length of time will lead either to constantly accelerating inflation or to a growth boom-bust (or both).
However, if policy can drive interest rates below this equilibrium rate for some short period, that can provide the economy with a temporary boost. From the 1930s to the 1970s, there was some speculation that it might be possible, under appropriate circumstances, to lock in the effects of a well-crafted short-term boost so that output was permanently higher.
But since the 1970s, it has been understood that loose monetary policy cannot make economies grow faster over the long term, but can, if done to excess, make them grow less fast. That monetary (and fiscal) policy can only create short-term boosts to output can be seen as the central lesson of macroeconomic policy of the past 40 years.
The upshot is that the policy ideal is never that interest rates be as low as possible for as long as possible. Policymakers should not need good reasons to move interest rates towards the equilibrium (“natural”) rate. They should need good reasons not to do that. Interest rate setting should be like a pendulum, naturally falling back towards the centre unless something intervenes to prevent it.
At present, the equilibrium interest rate compatible with a 2 per cent inflation target in the UK is somewhere between 3 per cent and 5 per cent (at the higher end if you are more optimistic about long-term growth; at the lower end if you are more pessimistic). But Bank Rate is 0.5 per cent, where it has been since early 2009, having never previously been below 2 per cent in the entire history of the Bank of England (and hence of central banks). Bank Rate was set to 0.5 per cent as a reflection of the emergency conditions of the 2008-09 financial crisis. That emergency now being behind us since 2010, the pendulum of interest rate policy should arguably have implied rates returning back towards 2 per cent some years ago.
Obviously rates were not raised then, and we know why – the Eurozone crisis and the associated stagnation in the UK economy. As it was feared UK banks might go back into crisis, there was a sense of secular emergency for several years. But even that sense of near-emergency has now passed. UK growth has returned, and sovereign debt yields across much of the Eurozone have eased. Now there is no emergency, there is no good reason for emergency rates.
That doesn’t mean we should be raising rates to 3 to 5 per cent, wherever we adjudge the current equilibrium rate to be. Policy should still be supportive. Just not as supportive. And we should also be sceptical about how much growth support is supplied by 0.5 per cent rates at all. After all, as said above, a central lesson of the past 40 years is that low rates cannot boost output over the long term. It’s been four years. Interest rate cuts are usually believed to exhaust their main stimulus impacts within 18 months to two years. So it’s not clear that, by now, there is any positive stimulus from 0.5 per cent interest rates at all.
In fact, exactly the reverse may well be the case. By keeping interest so low, we are keeping in place many “zombie” companies that would be liquidated at equilibrium interest rates. By preventing them from going out of business, we are tying up the capital and workers employed in those firms in unproductive non-growing activities.
Obviously we may not want to see all these zombies liquidated at once, as the re-allocation of all that capital and labour may be too much for the economy to do smoothly. But by raising rates a little, we can ease the economy off its dependence on emergency rates, a dependence that makes the economy less efficient and hence makes it grow less fast.
If we wait too long to raise rates, there is the strong risk that we get a self-feeding boom that drives up inflation and eventually means an interest rate spike. A stitch in time saves nine (per cent).
The economy is now growing, and has been growing fairly fast for over a year. That gives us an opportunity to raise rates, a little. By doing so, we may find we grow even faster even in the short term. But even if it means slightly slower growth in the short term, that will be a healthy step on the path to eventual normality.
Andrew Lilico is chairman of Europe Economics and a member of the Shadow Monetary Policy Committee.