Opinion: Coalition must resist the easy option of raising interest rates

When historians looking back on Gordon Brown’s career are searching for an epitah, they may well settle on the former Chancellor’s claim to have “abolished boom and bust”.

Questionable at the time it was uttered, the crash of 2008 rendered it a nonsense, but there are lessons to be learned for the coalition as they try to unravel the mess left by the Labour Government. The comment mentioned above is an example of a Chancellor falling victim to hubris, and the Coalition must be careful to not to be afflicted by the same condition.

Inflation and how best to prevent it wrecking the recovery is now at the heart of the economic narrative, as I indicated it would be.

And articles such as this indicate that the some coalition politicians and many business organisations favour taking the easy option of forcing inflation down by raising interest rates significantly over the next year.

This is certainly the easiest option, and the traditional method of government monetary policy management at this stage of the economic cycle for hundreds of years, until JM Keynes came along, but there is a danger that if the government take the easiest option then they could undo much of the progress towards economic stability which they have made since coming to office.

Raising interest rates will cause inflation to fall, but the price to the wider economy may be too high to allow the coalition to take this easiest of all options. Nick Clegg’s Chief of Staff Norman Lamb, speaking on Radio 4 on the day of the vote on tuition fees, listed one of the coalition’s achievements to date as: “we have fixed the economy”. This comment coming from someone so close to the Lib Dem leadership indicates that hubris may be entering the economic decision making process at a sensitive time in the economic cycle.

My contributions to this site have consistently been pro-coalition, and pro-coalition economic policy, but it is premature to say that the economy is fixed. A corner has been turned, but everything announced in the budget is spread over the cycle of the Parliament, and any policies on the monetary side, such as an interest rate rise, which are inconsistent with the fiscal strategy outlined by the Chancellor in the budget, will endanger the recovery.

Inflation is the major threat to the economy, but it is inflation which is largely on the supply side, rather than the demand side, while an interest rates increase is designed to address demand side inflation.

Supply side inflation is caused by the value of sterling against its peer currencies declining, making imports dearer, and the currency has declined because of the high rate of borrowing to fund the deficit. But if the rest of the coalition strategy serves to eliminate the deficit within the life of this Parliament, then the supply side inflation will decline as the deficit does. There may in time be a problem with demand side inflation, but there are specifc, targeted and effective remedies available in that area which wouldn’t damage the remainder of the economy.

So for the coalition to truly be able to claim to have ‘fixed’ the economy, they must maintain the current medium term view and not give into the temptation to raise interest rates to satisfy the short term concerns of the business lobby and certain Tory backbenchers, harking back to a time when interest rates were viewed as the only tool needed by governments to manage an economy.

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22 Comments

  • Fixed the economy?

    I really don’t know what dream land some people are living in…

    As for interest rates, they will rise…

    Some have forgotten the last Tory government, I have not, I can remember what they did, I can remember the high interest rates, the repossessions, and millions cast on the scrap heap…

    The first reasonable chance they get to influence interest rates upwards they will do so, even at the cost of bad policy, forcing the rate hikes… and guess what it will be shielded by Liberal Democrats in some shape or form.

    Jeez, I cannot believe that people don’t understand this… the Tory leopard has not changed its spots, we are heading for anything north of Watford becoming a third world area, because people will not be able to afford to rent let alone buy property, a few years or so before we see tent cities springing up to house the poor…

  • Interest rates are set by the Bank of England, not by government policy. Very few people expect them to rise dramatically or are proposing that they should.

    So I’m not really sure what this article is about.

  • David, you do write some…interesting pieces.

    The Coalition couldn’t raise interest rates even if it wanted to. That’ll be the BoE that does that.

    So your article has what purpose again?

    Lib Dems fixed the economy? Not even in your wildest dreams. 2011 will see just how wrong they’ve been.

  • You cannot claim even to have turned a corner – The deficit is still rising. This unreported fact seems to have been missed by Norman Lamb.

    With VAT rising; employment falling; consumer confidence waning; exports stifling; inflation rearing its head; the Euro on the precipice; the US still not in clear water; China continuing to devalue its currency; draconian cuts round the corner; growth at lower levels than Osborne needs… The Coalition is about to discover why Alistair Darling was right all along.

    And why Nick Clegg’s conversion to Thatcher-nomics was mistaken indeed…

  • Simon McGrath 1st Jan '11 - 6:15pm

    @cuse weren’t you going on about the double dip recession a few months ago?whatever happened to that.
    The article itself as others have pointed out is nonsense. The BOE sets interest rates and they will have to raise them if inflation continues to increase. Which of course is will due to all the printing of money/ quantitiive easing that has gone on.

  • Mike(The Labour one) 1st Jan '11 - 7:04pm

    Brown did end ‘boom and bust’, it’s just a shame that people don’t know what that actually refers to. There was no deliberately engineered boom before elections leading to a bust after them, no Maudling, Barber or Lawson booms. In giving independence to the Bank of England he ended that practice.

    Too many people think ‘boom and bust’ just means growth and recession. Let’s hope historians are better clued up than commentators.

  • Simon.

    There’s an established principle in economics.

    That is – don’t rule anything in or out.

    Those claiming that the risk of a double-dip has disappeared are more than foolish.

    This Coalition’s policies haven’t even begun to bite. The risk of a new recession as we enter the economic tsunami I’ve highlighted above is no less now than it was in May as Gideon entered number 11.

  • Simon McGrath 1st Jan '11 - 8:56pm

    @cuse I don’t rule it out. By you were predicting it was about to happen a few months ago.

  • Anyone with savings would dearly love interest rates to rise.
    Prudent elderly folk with no mortgage, who rely on interest from their hard-earned to top up their pensions, for instance.

  • @ Mike (The Labour One)

    Brilliantly inspired attempt to let Gordon Brown off the hook. Brown WAS referring to economic stability overall, and made a very big play of how many quarters there had been of positive economic growth. Until 2008, that is……

    Nice try, Mike, but your comment only goes to demonstrate how pitiful Labour’s state of complete denial is over its role in driving the UK economy and public finances to the brink.

    @ Cuse

    Only a Labour supporter could simultaneously oppose cuts and then moan about how big the budget deficit is. Classic.

  • RObert C.

    Only a Liberal could:
    i) Surmise that someone opposed to the shambolic policies imposed by this most right-wing of governments is someone apparently oppose cuts. Policies are separate from cuts to most sensible economists. That your party has decided that Gideon Osborne’s slash and burn economics is the right step for this country, with no serious plans for growth behind them is your responsibility. Remember – Little George only 2 years ago was lauding Ireland as they embarked on slash and burn. And look where that got them.
    ii) Deflect that the deficit is getting bigger and growth slowing even before little George’s policies are implemented by being tribal.

    I joined the Lib Dem party and voted for them on the basis of their policies at the last GE – and that included opposing Tory cuts. I take it you now believe the millions who did likewise should be doing a volte face on the same lines as Clegg + Cable and saying Gideon was right all along?

  • “A relatively low rise in interest rates might not be a terrible idea”

    I think that depends on whether you want repossessions or not, we don’t know the result of the cuts yet, we do know 80,000 odd people have just received notices of termination of employment, it could be six to eight months before we know how many of those lost their homes, raising interest upwards could tip the balance entirely.

    If rates go up by 2% or 3% over the next year to eighteen months, that is going to double a lot of mortgages to folks who are trying to recover from the cuts already dealt, history shows us what will happen, it is just a matter of when.

    Bad policy will force pressure on the BOE to take action, or should I say the results of bad policy will force the issue.

  • I’m not an economist and it appeared there was no consensus here as to what was likely to happen to interest rates.

    So I had a look online at what the experts were saying and you know what, they are all over the place as well.

    What that says to me is that we are in very dangerous times.

    Oh I note the comments about the BoE setting bank rate and not the government well I really find it hard to believe that pressure isn’t applied however what I haven’t seen anyone say is that the government sets an upper and lower rate of inflation for the UK economy and the bank rate is major mechanism iforstaying within the government-set range.

    So obviously the BoE isn’t quite as independent as some appear to believe. The other prob with the BoE is that their MPC seem unable to unanimously agree with what is required to control inflation. It would seem likely that the inflationary pressures from the VAT and fuel increases and train fares will create further inflationary pressure that will need to be dealt with. Apparently VAT alone will increase inflation from the current 3.3 per cent above 4 per cent,

    But there are so many possible external international pressures on our economy that the experts know we are walking a tightrope and one wrong move either way could result in economic disaster.

    An interest rate rise from 0.5% to 1.5% would add £87 to monthly repayments on a typical £150,000 home loan – an extra £1,044 a year. There is no doubt that the middle classes are going to be squeezed dry over the next couple of years even if they manage to keep a job.. They must be wondering what they did wrong – silly billies you voted LibDem and gave us Tory Government.

  • Ed The Snapper 3rd Jan '11 - 8:41am

    Gordon Brown’s boom and bust comment was very dimwitted. I thought so at the time and the OP is right to say that it will always haunt him. The idea that the ConDem government has “fixed the economy” is hilarious, though. Still, never mind, Gideon Osborne is enjoying a nice skiing holiday.

  • david thorpe 4th Jan '11 - 9:08am

    Thanks for the replies.
    @cuse
    I am aware that the BOoE set the rates, i was highlighting the dangers of them doing so, and saying that if the hubris displyed by Lamb becomes the general political narrative, as it id under brown then the bank may raise the r’ates.
    @Jim

    The last tory government was a shambles, but oit did, in 1997 leave a strong economy for labour, labour were so happy with it they maintained tory spending plans for the lifetime for their first oparliament in power.

    As to whether we have turned a cxcorner,
    Growth is above forecasts, and inflatioln above target, boith things which need to be happening at this stage of the economic cycle if the governments current straetgy is to work.
    The fact that the debate is now largely about the dangers of inflation, shows that the economic cycle has moved onf rom where itr was.
    I dont claim the econokmy is ficxed,, anyone who has rewad my piece will see that I am criticising Norman Lmab for making that comment, but

  • david thorpe 4th Jan '11 - 9:10am

    I do beelieve that the economy is moving in the right direction, as long as hubris doesnt ruin it.
    I have also shown with that link, that there are people advocating a raates rise

  • david thorpe 6th Jan '11 - 9:08am

    @jim

    you are correct that historically a rates rise would happen at thi stage, the ourpose of my article is to highlight that this has been a bad thing in the past and would be so now.
    However the bank of england have never controlled rates at this ppoint in an economic cycle and the lib dems havent been in government before, so history doesnt have to repeat itself

  • david thorpe 17th Jan '11 - 1:40pm

    the montary policy committee meet tomorrow to discuss raising rates due to infalationary pressure in the economy

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