What Should the Bank of England do to Interest Rates?
This is a question I sometimes ask my economics students. - If you were the Bank of England governor what would you do?
To be fair, the MPC have quite a few difficult choice to make. The decade of low inflationary continuous growth seem to be over. The current economic situation includes the unwelcome development of both higher inflation and lower economic growth. This deterioration in economic prospects comes against a backdrop of falling house prices, a shortage of credit in the banking system and record levels of personal and government debt.
In one regard, the MPC have a simple target - keep inflation between 1-3%. However, although the government only set an inflation target, it is assumed they will be sensitive to other issues such as economic growth and unemployment.
Recently, the Bank forecast that inflation will rise to 4% by the end of the year. This is not unreasonable given rising food and energy prices. In normal times this would require higher interest rates to reduce the inflationary pressure. However, these are not normal times.
This inflation is caused by rising costs and not rising demand. The rising costs are squeezing living standards and consumer spending. Furthermore, falling house prices are discouraging consumer spending. With this ‘double whammy’ of rising living costs and falling house prices, the last thing the MPC should do is to be increasing rates. Higher rates at this stage of the economic cycle could tip the economy from sluggish growth into a full blown recession.
The problem is interest rates cannot solve both problems of lower growth and higher inflation at the same time. It may be they just to live with a worse trade off.
Reasons to Avoid Increasing interest rates.
True, inflation is rising, but, even 4% is much lower than past inflation problems such as 27% in 1979, 10% in 1990.
Much of this inflation is hopefully short term. If oil prices stabilise, if the government doesn’t have above inflation tax rises, then next year, we should expect the inflation to fall in 2009.
The slowdown in the economy is going to be quite marked and will help to reduce inflationary pressure.
Why the MPC is talking of Increasing interest Rates
They are worried the current inflation may lead to a permanent rise in inflation and inflation expectations. For example, they are worried at the prospect of a wage inflation spiral following from generous wage increases such as the shell drivers.
Personally, I think the prospect of a recession is far more damaging than an inflation rate of 4%. The MPC need to show some flexibility, to stick to rigidly to an inflation target of 2% in the current situation, would be to chase the wrong target.
Original post by Tejvan R Pettinger