The Trivialisation of Monetary Policy
“The periodic interest rate announcements so avidly reported by the media obscure and may even undermine the serious work that the Bank of England should be doing.” PEF Council member Prof John Weeks argues for a new approach to monetary policy.
In early August the Bank of England announced that it would raise the rate at which it lends from 0.5% to 0.75%. The “real” (inflation deflated) rate is the nominal lending rate less the rate of inflation, implying the inflation adjusted increase is from minus 1.9% to minus 1.65%.
Anxieties about Brexit and how our economy might “overheat” were the stated motivations for this small increase. The empirical evidence in support of a need to take precautionary steps to stem inflationary pressures is quite dubious. For seven consecutive months our average inflation rate has declined, from 3.1% in November 2017 to 2.4% in June. A glance at the Financial Times shows considerable disagreement over the necessity of this modest rise by the Bank of England. Perhaps to allay anxieties in the wake of the rate increase a Bank of England expert sought to assure us that we can expect that interest rates “will remain low for 20 years”.
Why is an increase from 0.5% to 0.75% (-1.9% to -1.65% in real terms) important enough to make headlines? One possibility is its impact on mortgages. The BBC estimated the cost to variable rate mortgage holders adjusting for the average outstanding mortgage balances. The calculation estimated that the rate increase would cost £168 a year, or £3.23 a week (assuming that the increase passes through to private lending). In May 2018 (latest statistics) average weekly earnings were £517 a week (full-time and part-time). The calculated increase of £3.23 equals 0.6% of average weekly earnings.
Approximately 3.5 million households held variable rate mortgages that would be affected by the interest rate increase, or 12.9% of total households. The average earnings of these households are above the mean for all households. It follows that the probable impact of higher mortgage rates would be below 0.5% of weekly earnings for the one-eighth of all households holding variable rate mortgages. The mortgage cost impact on the other seven out of ten households would be zero. Taking all households together, the likely impact would be below 0.1% of average household earnings.
A second frequently cited victim of increase rate increase are small and medium-sized enterprises (ubiquitously known as SMEs). A business website estimates that the 0.25% increase would raise total interest payments in the first year on SME loans by £355 million (6.7%). According to ONS statistics, total SME turnover in 2017 was £1.3 trillion, implying that the rate effect would have been less than one-thousandth of one percent of 2017 turnover. The absolute cost would be about £1500 per SME. For large corporations loans from financial institutions have declined in recent years as a source of investment finance, replaced by stock issues and corporate bond sales. The link between the return on these junk bonds and the Bank of England rate is not empirically obvious.
On the “up side”, deposit rates might rise, increasing income to households and businesses holding savings in financial institutions. This is unlikely to be substantial, not least because most households do not save (except implicitly through mortgage repayments and compulsory or voluntary pension contributions). Moreover, commercial banks are under no pressure to pass through the latest interest rate rise to savers.
While these oft-mentioned effects are not negligible, they are not substantial. Why then do they consume much print in newspapers and commentary in the media? The question has a simple answer – economic ideology. A generation ago economic commentary on monetary policy addressed broad basic issues of fostering private investment, stimulating employment and financial regulation, to name the most obvious (Bank of England functions explained here).
The last thirty years ushered in the trivialisation of monetary policy, reducing it to an ideologically narrow focus on interest rates. This narrow focus derives from at least three basic fallacies. First, that a market economy naturally gravitates to full use of resources including labour. As a result the most important instrument of economic policy is the central bank rate, whose role is to enhance that automatic adjustment of private activity.
The second fallacy presumes that small adjustments in the central bank rate will quickly feed through efficient financial markets to moderate or stimulate inflationary pressures. And, moving full circle, is a third fallacy, that managing inflationary pressures will bring about the automatic adjustment to full use of resources, which serves as the ideological keystone of the trivialisation of monetary policy.
These three ideologically driven fallacies combine to perpetuate a fantasy image of Mark Carney, Governor of the Bank of England, as the steady pilot at the helm of our economy, sagely advised by his wise and dispassionate experts in the Monetary Policy Committee. Gentle tugs and pushes on the interest rate lever keep the economy healthy and stable.
This view of monetary stewardship bears little relation to reality. The periodic interest rate announcements so avidly reported by the media obscure and may even undermine the serious work that the Bank of England should be doing, as regulator of the financial markets that so disastrously destabilised the British economy ten years ago.
John Maynard Keynes still stands out as one of the great monetary theorists, in great part because he showed that monetary policy involves far more than fiddling with short term interest rates.
Photo credit: Flickr / Oliver Quinlan