In macroeconomic terms, this is a low-stakes debate.
On the one hand, even in economies where there is a link between economic activity and inflation – and I’m not sure the UK is among them – it is a relatively weak one. Phillips curves are quite flat, implying that inflation does not rise very far in response to lower unemployment. This means there is no urgent need to raise rates because inflation won’t soar if they don’t rise.
On the other hand, though, a rate rise wouldn’t be a disaster in macroeconomic terms. Bank of England economists estimate that a one percentage point rise in Bank rate only reduces GDP by 0.6 per cent, implying that a quarter point rise would take only 0.15 percent off of output. That’s not even measurement error.
The idea that monetary policy has big effects is therefore wrong. Modern economies don’t lurch from high inflation to recession, and certainly not (these days) because of monetary policy errors. They are more resilient than that.
This doesn’t mean, though, that the interest rate doesn’t matter. What’s at stake here is a wider philosophical question: should we impose big costs upon a few people to save millions from a small cost?
Here’s what I mean. Inflation is a nuisance. It causes us to try to economise on the amount of cash we hold, with the result that we need to make more trips to the bank. It means firms have to incur the hassle of changing prices more often. And because tax rates and allowances aren’t fully inflation-proofed, it means the tax system becomes more distortionary. These inconveniences might seem small, but they have measurable adverse effects upon well-being. Some economists have estimated that a percentage point of higher inflation depresses people’s life satisfaction by the same amount as a loss of just over £90. Across millions of people, this adds up. Insofar as a rise in rates holds inflation down, it therefore saves us a real cost.
However, rate rises also carry a cost, which is high for a minority. Economists at the Resolution Foundation have estimated that even a slow rise in interest rates, to 3 per cent by 2018, could lead to a near-doubling of the number of households in 'debt peril' (that is, whose debt repayments amount to more than half of after-tax incomes) to 1.1 million. What’s more, higher rates throw some people out of work – and all the evidence shows that unemployment is a massive source of misery.
These are not mere bugs, but features. Higher interest rates depress inflation precisely because they squeeze the incomes of those in debt and destroy jobs.
It is in this sense that the debate about interest rates is about a real and big issue: should we impose misery upon a few for the benefit of millions?
Strictly speaking, though, this should not be an issue for the Bank of England at all. In setting the CPI inflation target at 2 per cent, successive governments have agreed upon how to make this trade-off. Whether that agreement is at the correct point is, however, another question.
