Why, then, do so many think the Bank of England was wrong to leave rates unchanged?
One reason is that higher rates would signal that the Bank is determined to get on top of inflation and so would reduce inflation expectations – which in turn would hold down actual inflation.
This reasoning, however, has been challenged in a recent paper by Fed economist Jeremy Rudd. He argues that there is “no compelling theoretical or empirical basis” to believe there’s a link between inflation expectations and actual inflation. One reason for this is that it’s hard to identify causality. Imagine inflation expectations were to rise and that actual inflation subsequently rose. Does this mean that one caused the other? Or could it be simply that people saw the higher inflation coming in advance, and there’s no causal link between the two – any more than sending Christmas cards causes Christmas to happen?
A second reason to raise rates is simply that doing so reduces demand and thus inflation. You might object here that this channel is weak because fewer people are now on variable-rate mortgages. That misses the point. For one thing, higher short-term rates do eventually cut households' incomes because mortgage borrowers will face higher costs when their current fixed-rate deals end. And for another, higher interest rates work via the labour market. They deter some companies from hiring and cause others to shrink. That adds to unemployment, and higher unemployment surely reduces demand and inflation. Sure, the effect is small, but it is real and significant.
But this comes at a high price. There’s a human cost: the jobless are significantly unhappier than those in work, much more so than can be explained by a loss of income alone. And there’s also an economic cost. Unemployment deprives people of training and experience today, thus reducing future productivity. Joblessness, say David Bell and David Blanchflower, “leaves permanent scars on people” by reducing their future wages and probability of employment.
Which poses the question: why impose these costs (which include reducing the long-run supply potential of the economy) in response to what might be only temporary inflation? The Fed and Bank of England have judged this answer in the negative. It is possible that the squeeze on real incomes will depress demand and inflation anyway, and that. oil prices will fall soon (China's monetary growth is predicting falling commodity prices.) Of course, this judgment will change if inflation doesn’t drop significantly in the spring or if the economy proves stronger than expected and so able to take higher rates. For now, though, both banks have (at the margin) probably done the right thing in delaying a rise.
