The Bank of England has put the country on notice. There is a decent chance that interest rates will rise this year. That may seem like a sensible thing for the Bank to do, with inflation above the 2 per cent target and set to remain there for many months to come. The central bank playbook — the accumulated wisdom of generations of policymakers — suggests, however, that it should do no such thing.
The debate over the appropriate level of interest rates is all too often dominated by frankly futile disagreements about where the economy most likely is heading, or what economists call their best guess. Optimists call for rate rises. Pessimists call for rate cuts. Our disagreement with those at the Bank who want to raise rates does not fall into that category.
There are two compelling reasons not to raise rates, even if you agree with the Bank’s best guess of where the economy is heading. Those arguments are neither new nor controversial for the vast majority of central bankers, so we are surprised to discover that several policymakers at the Bank seem to think that raising rates is a good idea.
Lesson No 1 is that central bankers do not have to behave like “inflation nutters” and aggressively raise rates whenever inflation rises above the target. Interest rate increases only gradually influence the economy and slow the pace of inflation, so you should raise rates today only if you think you will have an inflation problem a year or two from now. In some cases, too much inflation today will go hand-in-hand with too much inflation in two years’ time if the central bank does not respond today, but this is not one of the situations.
If you want to understand why inflation is high today, you need to know only one thing: the value of the pound has fallen sharply. A weaker pound means that the price of the goods and services we import from abroad must rise if the overseas companies that produce them are to receive the same amount of dollars, euros and yen for their UK sales. The rate at which prices increase — inflation — will increase while import prices gradually adjust to the new lower level of sterling. Once that adjustment is complete, inflation will fall back. The Bank can afford to look through that temporary burst of inflation so long as domestic prices and, in particular, wages do not start rising in sympathy with import prices.
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There is little evidence that domestic prices have been disturbed by the shock to import prices. Wage growth remains anaemic. True, inflation has been surprisingly strong, but the logical conclusion here is that import prices are adjusting more quickly to the slide in sterling than was originally anticipated. A shorter adjustment phase means that inflation will climb higher but will also start dropping back sooner. An inflation nutter would raise rates here, but there is no need for the Bank to do that.
Lesson No 2 is that central bankers should follow a “risk management” approach when setting interest rates, which means taking decisions based on what might happen, not just on your best guess of what could
happen. There are two risk management arguments that apply now, both suggesting that rates should stay on hold.
First, central banks should set policy to ensure a good outcome on average. Imagine that your best guess is that the economy will be in reasonable shape one to two years from now but there is a risk of a very bad outcome. When the balance of risks is skewed in this way, you have to set monetary policy to engineer an overshoot in your best-guess scenario if you want to achieve a good outcome on average.
Why is this relevant today? Because the Bank assumes that the Brexit process will be smooth and there will not be a sharp break with the existing trading arrangements. That may be a reasonable best guess, but the risks around that judgment are surely skewed to worse and possibly much worse outcomes. Basic risk management suggests that the Bank should not dream about raising rates in these circumstances just because its best guess for inflation is above the target.
Second, central banks should plan ahead. The Bank has cut interest rates close to the floor and it has bought a huge portfolio of assets. There is not much more that the Bank can easily do to help if the economy takes a turn for the worse. Without monetary support, the next recession could thus be more painful and more prolonged than usual.
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The risk management doctrine says that the Bank should therefore try to minimise the chance that it finds itself running up against these constraints on interest rates and asset purchases in the future. The best way to do that is to deliberately overheat the economy: to aim for too much inflation on average. The more concerned central bankers are about the chances of another significant downturn, the more concerned they should be about their inability to turn the situation around and the more powerful the argument for aiming to overshoot on average becomes. Basic risk management suggests that the last thing the Bank should be doing is prematurely raising rates in these circumstances.
The real lesson to be learnt here is that before the Bank thinks about raising interest rates, it needs to think seriously about what would happen if the Brexit negotiations went badly. We were surprised to learn that as of May the Bank has not done that.
Our best guess is that enough people at the Bank are aware of these arguments to out-vote those looking to raise rates. There is no need to act like an inflation nutter. There is every need to think hard about the risks when there is little capacity to do more. There is every reason to leave rates on hold.
Richard Barwell is senior economist at BNP Paribas Asset Management
Anthony Yates is professor of economics at the University of Birmingham
Philip Aldrick is away