Bank must not follow ECB’s ‘futile gesture’ on interest rates
There’s an interesting article in today’s FT, entitled ‘In a tight spot’, which describes divergent policy towards interest rates in the US, the UK and the eurozone. This is prompted by the fact that the European Central Bank (ECB) is expected to raise interest rates today, by 0.25 per cent, while the US Federal Reserve continues to ease monetary policy. The Monetary Policy Committee of the Bank of England (MPC), which analysts expect to hold rates this lunchtime, is unfairly described as “sitting on the fence”.
The article neatly describes two things, one explicitly and one implicitly. It highlights, as if we didn’t already know, how interconnected the global economy is today. Higher eurozone interest rates would drive down the dollar, hitting continental Europe’s attempt at an export-led recovery (an attempt at which some are succeeding more than others). US inflation might accelerate as import prices rise. What Washington and Frankfurt do are of interest to economies thousands of miles away from Washington and Frankfurt.
More implicitly, it describes the contradictory challenges presented by the single currency. Support for higher interest rates in the eurozone is at its most pronounced in Germany, where the bailout of European economies seen as profligate is already unpopular. The ECB’s expected small rise in base rates would be designed to send a signal that it is serious about tackling inflation. But Greece, Ireland and now Portugal have more pressing problems, which will not be helped by a rise in the cost of borrowing. This is not an argument against the single currency, which brings valuable economic and political benefits to much of Europe, but it is a warning against an over-reliance on interest rates to tackle economic difficulties, very important though they are.
Political history casts a long shadow over the different policy priorities in Washington and Berlin. The US’s biggest economic shock of the 20th century was the Great Depression, making fears around economic growth the predominant concern, even 80 years after the event. Germany, meanwhile, remains scarred by the hyper inflation of the inter-war years and we all know the result of the political instability that followed. Policymakers in the US and Germany will say they want steady growth and low inflation, but in an economic period where they may feel they have to prioritise one over the other, it is easy to understand the divergence.
As for the UK, one of the reasons why Coalition Government arguments that we must tackle the deficit in the lifetime of a Parliament were always nonsense is precisely because we are not tied into a single interest rate. Our monetary policy can be led by the needs of the UK, not Germany, Greece or anywhere else. Right now, the UK needs to entrench growth. Elsewhere in the FT, it is reported that the National Institute for Economic Research (NIESR) forecasts that, over the final quarter of 2010 and the first quarter of 2011, the UK economy grew by just 0.1 per cent, “practically stagnant” in the FT’s words. This growth rate is much weaker than the Bank of England and the Office for Budget Responsibility had expected.
With the Coalition ripping demand out of the economy at a breathless pace, through its ill-judged spending cuts and VAT rise, the last thing we need is a monetary policy regime that will make matters worse. The UK’s 4.4 per cent CPI inflation (5.5 per cent on the RPI measure) is mainly due to food and commodity prices, which can’t be affected by higher base rates. This is why Mervyn King, the Governor of the Bank of England, is right to describe a potential UK rate rise as a “futile gesture” and why rates must be held at their present level until growth is sustained.