All eyes will be on the Bank of England’s next monetary policy meeting after its chief economist Huw Pill said the decision to raise rates “is finely balanced.” Which poses the question: don’t we make too much fuss about interest rate changes?
I ask because the Bank’s own research suggests the impact of them is small. It estimates that a one percentage point increase in Bank rate – which futures markets are now pricing in for the next 12 months – reduces output by “up to 0.6 per cent” after two to three years. This is not nothing: it implies destroying around 200,000 jobs. But nor is it a colossal amount: it’s tiny compared with the losses caused by the financial crisis, post-2010 fiscal austerity, pandemic or even (ultimately) Brexit. 0.6 percentage points is the difference between GDP growth one year being a little above the norm and a little below it. Countless other things (such as variations in commodity prices and global demand) have similar effects.
The focus on interest rates is therefore disproportionate to their effect.
And yet some influential economists are horrified by the prospect of them rising. Danny Blanchflower, a former MPC member, says it would be a "terrible error".
Error, yes. The economy is likely to falter soon even without a rate rise thanks to the squeeze on incomes caused by higher gas prices, tighter fiscal policy, ongoing fears about Covid-19 and weakness in the eurozone.
But terrible? Isn’t this hyperbole?
Not necessarily. The issue here is not that the Bank is underestimating the impact of interest rate changes. The fact that we’ve have 12 years of near-zero rates without triggering anything like an economic boom tells us that the effect of interest rates on output is modest, even if you don’t accept the Bank’s precise estimates.
Instead, the danger is of extrapolative expectations. A small rise in rates might be no big deal in itself, but it could lead to expectations of further increases.
And these would be a problem. For one thing, they would raise not just short-term borrowing costs but also longer-term ones: long-term rates, remember, are equal to the average expected short-term rate.
And for another, they could increase uncertainty. Put yourself in the shoes of a company thinking of expanding. You might think there’s little chance of a big rise in borrowing costs. But why take the risk? Why not instead delay investing until things are clearer. Economists have known for years that uncertainty curbs investment, expansion and hiring. That’s why serious politicians such as Margaret Thatcher and Gordon Brown were so keen on stability (even if they couldn’t deliver it): they knew that uncertainty was bad for the economy.
For this reason, a big part of the Bank’s job is managing expectations. Whatever the Bank does at its next meeting, it will stress that any future rises will be limited and gradual. The fact is that the economy is not strong enough to take even quite weak monetary policy medicine. This is not just because of higher gas prices and fiscal tightening, but also because of longer-term forces that have depressed growth for years. These forces deserve more attention than the question about where interest rates are heading.
