Interest rate rises, choices and consequences

Good morning from New Economy Brief. 

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On Thursday the Bank of England’s Monetary Policy Committee (MPC) will decide whether to continue raising interest rates or hit the pause button. Central banks have been increasing interest rates around the world in reaction to record inflation, but this blunt tool has consequences for other parts of the economy, perhaps most notable in contributing to the instability of financial institutions.

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In todays’ Digest we look at the debate around the MPC decision, the interaction between interest rates and other economic issues, and examine other tools which could be used to combat inflation that avoid such harmful effects.

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Have interest rates peaked? This Thursday the Bank of England’s Monetary Policy Committee (MPC) will vote on whether to increase, maintain or reduce interest rates. Many economists have debated about whether the MPC should keep interest rates at their current level of 4% after a particularly turbulent week in financial markets. The last few weeks have also seen a remarkable public debate between MPC members about the course they should take. 

• The hawks. The February meeting of the MPC concluded with a majority vote of 7-2 to increase the Bank Rate by 0.5% to 4%, with two members voting to maintain rates at 3.5%. The ‘hawkish’ members of the MPC expressed concern that a historically tight labour market and potentially ‘sticky’ private sector wage growth above 6% “risks of greater persistence in underlying inflation” which a 0.5% hike would help address a ‘second round’ of inflation. Catherine Mann has been clear in public that she feels that more rises are necessary.
• The doves. The ‘dovish’ members of the MPC (Silvia Tenreyro and Swati Dhingra) argued that the real economy remained weak as a result of falling real incomes, that the economic downturn was affecting the labour market, and that the impacts of previous hikes are yet to have their impact, so inflation is likely to reduce “well below” 2% in the medium term, even with interest rates remaining at 3.5%. 

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Are rate rises harming the economy? The debate has shone a light on the effect of contractionary monetary policy on the wider economy. Economists have long argued that using interest rates to combat inflation is an imprecise tool, particularly when price rises are mostly driven by external supply shocks rather than domestic demand. Increasing the cost of borrowing and voluntarily slowing down demand in the economy on the brink of recession has a variety of adverse impacts on public debt, mortgages and the housing market, international debt repayments, business lending, unemployment and financial instability.

• They increase costs of government debt servicing... Interest rates have massive political effects as they change the cost of servicing government debt which has implications for how much ‘fiscal space’ the Treasury has to meet the Chancellor’s (self-determined) fiscal rules. These may be more political constraints than real economic constraints, but if the government is determined to meet these rules then there are real consequences for raising rates on fiscal policy. The Office for Budget Responsibility’s (OBR) latest report noted (page 14, 1.24) that if interest rates were 1% higher (or lower) than assumed in their forecast, borrowing would cost the government £20bn (0.7% of GDP) more (or less) to service their debt in 2027-28, which “would wipe out headroom against debt falling in the higher rates scenario but would more than treble headroom in the lower rates scenario.” Thus the decision of the MPC will have a dramatic effect on the pre-election fiscal context and could scupper any government plans to ‘spend’ additional headroom on pre-election tax cuts. 
• …slow down economic growth... The OBR’s latest economic and fiscal outlook noted (page 6, paragraph 1.4) that the lower interest rate pathway was partly responsible for avoiding recession - another key factor determining the government’s narrative around the Budget. 
• …spark international debt crises... The 1980s was marked by a series of international debt crises in South America and Africa as developing economies struggled to service the higher cost of debt as creditor countries increased interest rates in response to rising inflation during the oil shocks of the 1970s. As central banks across the developed world hiked interest rates in response to recent inflation, a recent report from the International Panel of Experts on Sustainable Food Systems warns that 60% of low-income countries and 30% of middle-income countries are at high risk of (or already in) debt distress as government’s struggle to service higher debt. 

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…and have triggered a banking crisis. A new factor has been added to the mix in recent weeks as turbulence in global financial institutions has been traced back to rising rates, prompting calls for a pause. As debt gets increasingly expensive, companies and industries that flourished in the era of super-low interest rates are more likely to default, which can lead to bank collapses. Last week Silicon Valley Bank (SVB) collapsed as higher interest rates in the US left the bank increasingly exposed and eroded the value of its long-term bond portfolio, triggering a sell-off of stocks and an international banking crisis.  Commenting on the failure of SVB, a timely peer reviewed article explains how rising interest rates erode the value of bank assets and have put “almost 190 banks at potential risk of impairment to insured depositors, with potentially $300 billion of insured deposits at risk” in the US. Tulip Siddiq, Labour’s Shadow City Minister, wrote to the Chancellor earlier this week to call for a “systemic review of the impact of interest rate rises and the wider uncertainty in the global banking system on our financial sector and economy.”

• This is also a warning against financial deregulation. The situation is unfolding rapidly, but the Finance Innovation Lab’s Jesse Griffiths explains that the reaction of central banks “shows we have a real financial crisis on our hands…only powerful state intervention can prevent the crisis spreading across the whole system” and warns against further financial deregulation. The US’ Federal Reserve also provided more lending to banks through its emergency funding programme last week than at the 2008 crisis peak. Chatham House expert Creon Butler concurs that the episode teaches us a key lesson: “Governments and financial regulators should be very cautious about relaxing regulations put in place to protect the financial system after the global financial crisis. This is as true of the UK’s desire to take advantage of post-Brexit freedoms, as it is of those in the US who see ‘excessive’ financial regulation as a constraint on growth.” (See our previous Digest on the UK government’s plan to deregulate financial services.) 

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Are other central banks still increasing interest rates? The Guardian’s Richard Partington reports that the SVB collapse ‘could force central banks to stop interest rate rises’. Market expectations for where the US’ Federal Reserve will peak interest rates have also dramatically reduced since SVB’s collapse (Look out for their decision at 6pm tonight). Expectations for the European Central Bank (ECB) peak interest rate have also reduced, although their Governing Council still increased rates by 0.5% last week as “macroeconomic projections were finalised in early March before the recent emergence of financial market tensions”. The FT’s Delphine Strauss reviews the views of former central bankers in light of recent financial turmoil.

• Latest market projections for the UK interest rate. Even at the last MPC decision in February and before the emerging banking crisis, many brokers argued that the Bank of England shouldn’t increase UK interest rates further. Capital Economics’ Paul Dales notes that “The fact that problems in the banking system...can be traced back to the rises in global interest rates means it is natural for the MPC to become more wary about further tightening the screws.” The latest market expectations for UK interest rates have reduced since the collapse of SVB but now expect a further 0.25% rise tomorrow due to an increase in CPI to 10.4% in February (up from 10.1%) in ONS data published this morning.

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Reviewing the UK’s macroeconomic institutions. This is the first major inflation crisis since the Bank of England became independent in 1997, and it is reasonable to ask what lessons we can learn about the policy response to the inflation shock. Arguably, the whole episode has exposed the danger of relying almost exclusively on interest rate rises to combat inflation which is driven by external supply shocks. As economist James Meadway notes, “The primary function of a central bank… is to preserve financial stability. If this primary task conflicts with the demand that they must also try and keep inflation low, central banks should be focused on their primary function. This means, in practical terms, that the fairly useless programme of interest rate rises must be halted and support given to banks as needed.” But if we accept that aggressive rate rises have limited ability to control certain kinds of inflation, and have damaging consequences elsewhere, then what other options exist?

• Time for fiscal and monetary coordination? A working paper for CUSP explains that the current monetary and fiscal policy regime “is no longer fit for purpose and may end up hampering both the recovery from the pandemic and the transition to net zero”. They call for a greater degree of flexibility in the UK’s macroeconomic institutions (Page 22-25) so that fiscal policy can “take a more active role in managing economic activity, and for monetary policy to take consideration of public (and indeed private) debt sustainability issues when setting interest rates.”  Economists Jo Michell and Jan Toporowski argue that the Bank of England should be given an enhanced financial stability mandate requiring more explicit coordination with the Treasury, “but need not eliminate the independence of the Bank”. They argue that the pre-2008 crisis orthodoxy of inflation-targeting was “incorrectly credited for a period of macroeconomic stability that was subsequently shown to be illusory”, and review a variety of proposals for reforming monetary policy (Page 23-29) including replacing the Bank of England’s inflation targeting with a growth target, and more. The authors ultimately conclude that “the proper regulation of employment and investment in the economy is a matter of policy for Government, not the central bank.”

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Alternative ways of reducing inflation. The government can also reduce inflation through use of targeted fiscal policy and more active competition policy.

• Fiscal price caps. IPPR have outlined how “a less often discussed, but potentially hugely important, macro-economic policy lever is to use fiscal policy to reduce prices immediately”, such as freezing the energy price cap, which they calculated could drastically reduce inflation in the UK (written before the Truss administration implemented the Energy Price Guarantee). 
• Competition policy. Isabella Weber in the US and IPPR and Common Wealth in the UK have been problematising corporate concentration as an explanation of rising prices after the pandemic. In Prices and Profits after the Pandemic, Carsten Jung and Chris Hayes find that “While inflation is primarily being driven by global factors… surging profits by some companies could be a contributing factor to rising prices…[where] the market power of some firms could be exacerbating inflation.”IPPR’s Carys Roberts proposed the government should levy excess profit taxes to other sectors of the economy which have made windfall profits (beyond oil and gas) and use the receipts to support households and build more resilient supply chains to tackle external causes of inflation (e.g. for critical commodities). This could reduce inflationary pressure by discouraging profiteering, as research by IPPR and Commonwealth has observed.