Economists expect the Bank of England to raise Bank rate by a quarter point to 0.5 per cent next week. Many, however, think it shouldn’t do so. Legg Mason Western Asset’s Andrew Belshaw says the moves would be a “mistake”, and Investec’s Philip Shaw says he has “misgivings” about it.
It’s easy to see why. Probably the biggest macroeconomic surprise this year has been the failure of wage inflation to rise. This suggests there’s no danger of a wage-price spiral and that consumer price inflation will soon fall as last autumn’s rise in import prices falls out of the data. What’s more, stagnant productivity might continue to squeeze real wages and hence consumer spending, while capital spending will continue to flatline, all of which points to continued weak growth.
On the other hand, though, the Bank’s own work suggest that even if the move would be a mistake it wouldn’t be a big one. Bank economists estimate that a quarter-point rise in rates reduces output by only around 0.15 per cent.
Two things, however, suggest this might understate the impact of a rise next week. One is that it would be the first rise for over 10 years and so would have the shock value of being unfamiliar. This could be magnified by the fact that people are more sensitive to proportional changes than absolute ones: psychologists call this the Weber-Fechner law. A move from 0.25 to 0.5 per cent might therefore be more traumatic than one from (say) 5 to 5.25 per cent.
Also, as a report last week from the FCA showed, millions of people are financially fragile and can’t cope with higher outgoings. It found that one in seven borrowers “would struggle to pay their mortgage if repayments went up by less than £100 per month".
You might reply that this would be offset by higher incomes for savers. Mathematically, this isn’t quite true: households’ bank debt exceeds their deposits by £1.55 trillion to £1.37 trillion. Nor is it necessarily behaviourally true. If we beneficiaries of a rate rise save our gains, or respond to them by retiring earlier or cutting our working hours, there’ll be no expansionary effect to offset the hardships of the indebted.
Given all this, you might think I sympathise with those calling the rise a mistake.
Not entirely, for two reasons.
First, the fact that millions would suffer from higher interest rates is not a bug but a feature. Higher interest rates reduce inflation by depressing demand – and they do this in large part by forcing highly indebted people to retrench. When John Major said of tight monetary policy in 1989 that “if the policy isn’t hurting, it isn’t working” he made the fatal if unusual error of the politician: he told the truth.
Secondly, talk of a mistake is misleading, as it carries connotations of a deviation from competence. In fact, though, policy mistakes are normal and inevitable. This is simply because monetary policy must be set according to a forecast of economic conditions and forecasts are unavoidably wrong simply because the future is to a large extent inherently unpredictable. The idea that monetary policy can be perfect is a utopian fantasy.
Yes, a rate rise might well be a “mistake”. By the low standards of policy-making, however, it might not be a catastrophic one.
