Finance and economics: what we have learned, and what still needs to be done – part 4

This week Liberal Democrat Voice is running a series of articles from Tim Leunig about the economy – how we got here and what we should do next. So far the series has covered bank bailouts, bank lending and fiscal policy.

Interest rates and the Bank of England

The Bank of England’s monetary policy committee has done well. They did not rush to cut interest rates when inflation still looked to be a real threat (don’t forget that this summer saw the highest level of inflation for a decade). But as soon as there was a serious prospect of deflation they cut interest rates dramatically, and have made it very clear that they would do so again.

The bank has been given a job to do: keep inflation on track. Exogenous events, such as the huge oil price rise, mean that inflation cannot be held perfectly on track. But the Bank of England has done as well as anyone could expect. Calls to change the Bank of England’s mandate as soon as we don’t like a particular decision are at best foolish.

Anybody who has read the recent Bank of England minutes will know that the Bank cut interest rates to 3% because that is what they thought was needed to keep inflation at 2%. They did not do it to refloat the economy. The fact that deflation rather than inflation is now the threat shows us that stagflation is not an issue: we are not back in the 1970s. Were inflation to be a threat the Bank of England would be raising interest rates rather than cutting them (and would be right to do so). That inflation is not a threat, and that we have not entered the wage price spiral is a demonstration of just how successful Bank of England independence has been, and demonstrates more generally that inflationary expectations are fairly low, and that workers are sensible enough not to demand high wage rises when doing so would simply lead to unemployment. The contrast with the 1970s is very apparent, and must make it less likely that unemployment will surge in a way that it did in the late 1970s and early 1980s.

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  • “workers are sensible enough not to demand high wage rises”

    They are? I dont see much of Unions saying “we wont put in a high claim this year” yet…

  • Quite Aaron.

    Interest rates should have come down over the summer when it was clear the commodity price bubble had run its course. The fact that the MPC (bar one) failed to see this is quite incredible.

  • We still had high inflation at that point.

  • Hywel Morgan 27th Nov '08 - 2:34pm

    “I think you’re giving the MPC far too much praise, they failed to act on the property bubble,”

    Property prices weren’t part of their remit – except in as much as they affected CPI inflation which they don’t seem to have done.

  • So how high are you saying % should have been? They would have had to have been pretty high indeed to stop house price rises over the last few years.

    House price problems are caused above all by problems in the housing market

  • Hywel Morgan 27th Nov '08 - 8:56pm

    Tim could probably confirm this but I think interest rate rises would have limited effect on curbing price rises. It also gives them a contradictory brief. At several points cooling the housing market wanted a rate increase whereas other conditions required a cut – eg post 9/11

  • Interest rates are reasonably effective at controlling inflation 9 years out of 10 – it has been on target for 9 out of 10 years. Whether it works now – we shall see…

  • Hywel Morgan 27th Nov '08 - 11:16pm

    Sorry Tim – I mean curbing *house* prices. So a vastly different point 🙂

  • The MPC got it wrong month after month (with the exception of David Blanchflower). Even in September they still saw inflation as the threat. In April Blanchflower predicted house prices could fall by a third. In May he said the number of jobless in Britain could reach 2 million by Christmas. Meanwhile, King and the others ignored him and held rates too high for too long. The recession will undoubtedly be deeper than it needed to have been as a consequence.

    As for wage inflation – this hasn’t been a threat for a long time, there was a very well argued analysis again from Blanchflower on this point earlier in the year (March?).

  • Tim,

    Playing devil’s advocate – but only a bit, because I think these scenarios are a real risk too many are ignoring.

    The experiment carried out by the Bank of England’s monetary policy committee has not worked out well. They did nothing to head off the housing bubble, largely because they were not responsible for it, but they did provide a fig leaf for Gordon Brown to cover up his mismanagement of the economy, and by splitting responsibility into two, allowed him to confuse the issue and pretend all was well.

    The need to change the overall control structure back to an integrated one is clear for all to see. Domestic inflation has been allowed to run riot in inefficient service industries which could hide their inefficiencies under fictitious rises in asset values, while manufacturing has gone further to the wall as it is faced with real international competition. Prices of imports have been driven ridiculously low, due to the China effect and the excessive value of the pound. This is now unravelling.

    Stagflation may again become an issue as we no longer have a diverse economy, with little manufacturing industry in place to benefit from a falling exchange rate. The wage price spiral will not be the problem; it will be the exchange rate price spiral. I believe there is a real problem here and economists are still fighting the old war (against inflation) and not the new one.
    Finally unemployment could surge drastically not like in the 1970s and 80s, but because we are so dependent on financial services to drive the economy and that area is the one that is failing the most.


  • Tim,

    It seems they agree with you at CentreForum.

  • Cutting 0.5% in May – which is what I recollect Blanchflower advocating – would not have prevented the downturn, or done much to mitigate it. A 0.5% cut 6 months ago is not a big thing compared to what has happened this autumn.

    Cutting earlier could have made things worse: lower borrowing costs, more debt, higher house prices, and now bigger problems.

    As Hywel says, % are not particularly effective at curbing house prices – or rather, the rates needed to curb the rises over the last few years are high (more than double, on average). That in turn would have raised £ even higher, destroying large parts of the economy. If we want to dampen oscilations in house prices we need supply to respond to demand, just as in the rest of the economy.

    Manufacturing output (in volume terms) continues to rise, although rises in productivity mean that manufacturing employment falls. Whether the £ is at $2 or $1.50 makes little difference in competitiveness cf China: our future has to be in the high skills sectors of the economy, mfg or services.

    I don’t think we are likely to see unemployment rise in the way of the early 1980s, since there is no obvious need to shake out uncompetitive sectors (finance is much smaller now that mfg, mining etc was then). But peak unemployment may well be higher, because the economy has been poor at finding work for low skilled males, particularly those living outside the SE of England. So we start with more “non-active” males as a baseline.

  • Its a nonsense to say that cutting interest rates earlier would have made things worse.

    Change in monetary policy only affect the real economy with a substantial lag. Therefore those in charge of monetary policy need to be forward looking.

    As late as September the MPC minutes stated “most members judged that maintaining Bank Rate at 5% this month was necessary if inflation was to be brought back to the target in the medium term” and that “a case could be made for an increase in Bank rate”.

    Yet since the end of 2007 a many forward looking surveys of UK economic activity have indicated a marked downturn. Look at the GFK Consumer Confidence Surveys, the CBI Industrial Trends Survey and the BCC Quarterly Surveys for examples.

    In any other profession anyone making such a bad judgement call would be out of a job. For economists the rules appear to be different!

  • Mark Inskip 1st Dec '08 - 2:01pm

    Tim wrote ‘Manufacturing output (in volume terms) continues to rise’
    Really? Today’s drop in the Purchasing Managers’ Index from 42.4 to 34.4 is consistent with manufacturing output contracting at an annual rate of around 10 percent!

  • Mark Inskip 9th Dec '08 - 10:17pm

    And guess what, the ONS figures today show manufacturing production fell by 1.4% in October.

    I see Tim has gone very quiet on this subject!

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