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Reasons to cut rates

There's a bad reason for the Bank of England to cut interest rates next week, but also two good ones
January 23, 2020

The Bank of England might cut interest rates next week. There’s a dubious reason for it to do so, but two good ones.

The dubious reason is that it must respond to the weak economy. Latest data show that real GDP grew by only 0.1 per cent in the three months to November 2019, and that the level of GDP in November was lower than in the summer.

Monetary policy, however, cannot change the past, only the future. And there are reasons to suppose that we could see an upturn soon.

For one thing, the reduction in political uncertainty, plus a little decline in uncertainty about Brexit, might case some firms that have put investment and hiring plans on ice to unfreeze those plans.

Also, we could see an upturn in the eurozone economy, which would lift our exports and business confidence. Next week’s figures should show that narrow money growth in the region has accelerated recently. Such pick-ups have been a lead indicator of recoveries in output.

And on top of all this, the UK chancellor is expected to use March’s Budget to announce a relaxation of fiscal policy. That too would boost demand.

We might not therefore need a rate cut to support growth. Other things will do so.

Instead, there are two better reasons for a rate cut. One is that the fall in Consumer Price Index (CPI) inflation in December to just 1.3 per cent, a three-year low, tells us something. It tells us that the Bank of England has called inflation wrong. It has expected that a lack of spare capacity in the economy would raise inflation. But it hasn’t. One reason for this is that there’s much more slack than it thinks: there are for example 3.3 million people who aren’t working as many hours as they’d like. Another reason is that companies don’t respond to capacity constraints (even where they exist) by raising prices but by finding ways to eke out more production.

The Bank should therefore cut rates simply because inflation is less of a danger than it has thought.

But there’s another reason to cut – risk management. The Bank does not base its monetary policy only upon a central forecast simply because all such forecasts can be wrong. It must also consider the balance of risks. And the risks are asymmetric.

Let’s suppose that I’m wrong and that inflation takes off. If it does, then the Bank has proven tools to tackle this problem: it can simply raise rates.

But suppose inflation continues to undershoot its target or that the economy remains depressed. This would require big rate cuts. But it’s not clear that negative rates boost the economy: they are a tax on banks and savers. And while there are several possible other options the Bank has, such as more quantitative easing, subsidies to bank lending or simply giving people money, nobody knows for sure what the correct dosage of such policies should be. As Oxford University’s Simon Wren Lewis says: “The trouble with unconventional monetary policy is not that it does not work, but it does not work reliably.”

The best way to cope with this danger is to avoid it in the first place. Which means that monetary policy should err on the side of expansion. If the Bank cuts rates and is proved wrong to do so, it can correct its error easily. If, however, it errs on the side of tightness the mistake is not so easily corrected.