Raise our low interest rates now or this ticking time bomb will explode
DESPITE the UK slipping back into “official” recession, the Bank of England should begin to start raising interest rates. The policy rate it controls has been historically low for several years, and is significantly below where it would be if it were allowed to reflect demand and supply. Almost all commentators claim to accept that rates need to go up at some point, so the only real debate should be about timing. So let me ask a question: under what conditions would it be appropriate for the Bank of England to begin normalising the policy rate?
Earlier this year I advocated keeping rates on hold, on the grounds that the euro was on the brink of collapse. I felt that, until we saw whether Greece was able to restructure its debts before the 20 March deadline, it would be wrong to tighten monetary policy. But that has now passed. Yes, the Eurozone is still in a perilous predicament, but if you think the Bank should wait until it has been resolved, you are effectively committed to permanently low interest rates.
Some argue that growth is too low to warrant a tightening of policy, but even if the “official” estimate of GDP from the Office of National Statistics is correct, it is hardly a crash. Growth has been bobbling along between a band of -0.5 per cent and +0.7 per cent for almost two years. If you’re waiting for GDP to be where it was during the boom years, interest rates would stay low indefinitely.
Finally, economists dismiss high inflation on the grounds that inflation expectations are in line with the Bank’s target of 2 percent. But if you wait until people lose faith in the central bank to deliver on its goals, monetary policy ceases to function in the normal way. If you wait until the horse has bolted, it’s too late to shut the stable door.
There are massive risks involved in raising rates now, but waiting for the “right” conditions is foolish. Policymakers face a tradeoff between risks on both sides of the debate.
My chief concern is that more and more members of the general public are getting used to these temporary, emergency interest rates and factoring them into their forward decision making. Some refer to this as “interest rate inertia”. Around 40 per cent of mortgage holders are now on the standard variable rate and, regardless of what the Bank of England does, this is already starting to rise. Mortgage lending was up in February (and not just for those who enjoyed a stamp duty holiday), and average deposit rates are falling again. Not only do low rates encourage mortgage holders to pay off too little of the capital value of their borrowing, but they also encourage people that cannot afford mortgages to take them out.
Interest rate rises are a ticking time bomb, and the longer they remain low the more people are likely to be exposed to rises. The choice policy makers have is between a restricted detonation now, or an uncontrolled explosion later. I’d opt for the former.
Anthony J. Evans is associate professor of economics at London’s ESCP Europe Business School. www.anthonyjevans.com [email protected].