Bank of England should not be too trigger-happy on interest rates
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Version 0 of 1. This year, next time, sometime, never. The Bank of England has been conducting its own version of the old party game as it leaves us guessing about the timing of the first increase in interest rates. Mark Carney, who prides himself on being a great communicator, seems to have a different message depending on which day of the week it is. Some sympathy for the Bank is warranted. It was always going to get tougher to set borrowing costs once the economy started to recover, and growth has been strong now for more than a year. When the official figures for the second quarter of 2014 are released next month they will show that national output is back above its pre-recession levels in early 2008, albeit still well below its former peak in per capita terms. Inevitably, therefore, the Bank has started to think about when it might abandon the emergency interest rate of 0.5% that has now been in place since early 2009. This is not a prospect that fills George Osborne with dread: on the contrary, the chancellor would see it as a sign that the economy was properly on the mend. The Bank's thinking goes like this. Monetary stimulus is still justified because the economy is considerably smaller than it would have been had the global financial crisis never happened. There is, despite the recent fall in unemployment, spare capacity that can be used up before the UK starts to experience inflationary pressures. The amount of slack is clearly smaller than it was a year ago, when national output was 3% lower, but there is still some there, most of it in the labour market. To help the Bank's monetary policy committee (MPC) decide when to raise rates, its economists need to have a view on how much spare capacity there is. Unemployment is higher than it was before the recession and there is also underemployment caused by some people in work saying they would prefer to do longer hours. All things considered, the Bank says, the equilibrium unemployment rate is between 6% and 6.5% of the workforce. Were the actual jobless rate to fall below this level, it would start to generate upward pressure on inflation unless there were offsetting downward pressures caused by long-term structural changes to the labour market. The current unemployment rate is 6.6%; hence the growing speculation that the first increase in interest rates might be just around the corner. Since the 1980s, economists have believed that there is a level of unemployment consistent with steady state inflation (the so-called NAIRU or non-accelerating inflation rate of unemployment), and if the Bank is right then Britain is getting quite close to it. As Lombard Street's Brian Reading notes, this is making the MPC "trigger happy". There are, though, reasons for the MPC to be careful about pulling that trigger. The first is well made by the HSBC economists Stephen King and Karen Ward. They make the point that economic forecasts have been strongly "framed" in the aftermath of the financial crisis. "Faced with massive uncertainty, economists have, for the most part, stuck to simple rules of thumb: growth is likely to come back to its long-term trend, while inflation is likely to be close to central banks' arbitrarily defined targets. These rules of thumb have not worked terribly well." King and Ward note that, in defending their projections, forecasters use the concept of the output gap, the notion that it is possible to measure by how much an economy is operating above or below its long-term trend rate of growth. If it is below potential, policy can be kept loose, if it is above potential policy needs to be tightened. Measuring the slack in the labour market is the Bank's way of assessing the size of the output gap, but King and Ward say it is drawing a "precision-engineered conclusion ... from a very flaky concept". Pessimism Historical evidence is useful here. Back in the 1980s, unemployment in the UK rose above double digits and it was assumed that much of the joblessness was structural rather than the sort that would be eliminated once the economy started to grow strongly. Such pessimism proved to be unfounded. Unemployment fell steadily without causing any upward inflationary pressure, forcing economists to revise down their estimates of the NAIRU. In the jargon of the economics trade, there has been a flattening of the "Phillips curve", a relationship between wages and unemployment first explored by the New Zealand-born Bill Phillips in the late 1950s. The Phillips curve was seized upon by policymakers in the 1960s because it suggested they could pick and choose between a bit more inflation and a little less unemployment (or vice versa). The concept went out of fashion in the stagflationary 1970s, but if there is a relationship between wages and inflation all the evidence since – including that since the financial crisis – is that it takes a big and sustained fall in unemployment to prompt an acceleration in wage growth. This point is rammed home in a paper by David Bell and David Blanchflower that will appear in the next quarterly review from the National Institute of Economic and Social Research. Bell and Blanchflower note that the equilibrium unemployment rate falls when unemployment itself is falling, but they are also highly critical of the way the Bank has come up with its estimate of spare capacity, saying that Threadneedle Street has made arbitrary downward adjustments to the amount of labour market slack in the UK. In particular, Bell and Blanchflower say the Bank is wrong to assume that the long-term unemployed put less downward pressure on wages because they have been out of the labour market for some time. There is, they say, no evidence to support this. Nor is it valid to assume, as the Bank does, that the underemployed exaggerate the amount of hours they want to work. Bell and Blanchflower point out that the last time the economy was operating at close to full employment – just before the financial crisis of 2007 – there was no reported underemployment but today it is so widespread that it would add 1.8 percentage points to the unemployment rate. Underemployment will disappear, Bell and Blanchflower say, when the economy again approaches full employment. They add that the last time interest rates were raised in July 2007, the total underemployment rate stood at 5.8% – 5.5% unemployment plus 0.3% underemployment. Today the equivalent figure is 8.4% (6.6% plus 1.8%). All of which helps to explains three things: why there has been much less wage pressure than the Bank of England has been predicting until now; why there is likely to be less wage pressure than the MPC is anticipating in the future; and why the MPC should be wary of those who say looming wage pressures justify an immediate ratcheting up in interest rates. |