Interest rates: there is danger in acting too soon

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In this blog we have previously discussed the impact that rising commodity prices could have on manufacturers in the year ahead. Simply put, sustained cost pressure as a result of growing global demand for commodities, would lead to persistently above-target inflation.
The question regarding interest rates has now moved from asking if they should be raised, to when they should be raised.
The Sunday Times yesterday reported that its shadow Monetary Policy Committee had voted 5-4 in favour of an immediate interest rate rise. And not the 25bp rate rise Sentence and Weale have called for. The SMPC recommended increasing rates by 50bp, taking the central bank rate up to 1%.
The SMPC voted this way for three reasons:
1. That the depreciation of sterling (which has caused an increase in the general price level) is partly a result of low interest rates.
2. That the global economy is closer to overheating than depression.
3. That the MPC is at risk of losing the credibility that allows it to control inflation as a result of persistently above-target inflation.
The first point is true, but there is no reason to think that current central bank policy would cause sterling to depreciate further. As inflation is a measure of the change in prices, there is therefore no reason to think that keeping interest rates constant would have any upwards inflationary pressure.1
The second point is a concern because global overheating would cause increased commodity and input prices. However, there is little that a rise in the base rate could to do offset this, except that it might cause sterling to appreciate, but this would be damaging to growth in other ways because it would make our exports relatively more expensive.
This leads neatly to the SMPC's third concern: the MPC's credibility. Now, while it is the case that the MPC's role is to keep CPI inflation close to 2%, it is also within its remit to be mindful of economic growth. Economic growth since the recession has been unsteady. And, as concerns over global overheating make clear, most of the cost pressures faced by the UK economy are externally driven, making domestic monetary policy less effective.
Domestic monetary policy less effective in the face of externally driven price pressures, and early rate rises could also have a serious impact on growth.
We have modelled a scenario where there are sustained commodity and oil price rises.2 In this scenario – even if the MPC intervened with modest rate rises (to about 1.75% by the end of 2012) – the rate of CPI inflation would remain around 3% for at least the next three years.
This could undermine the MPC's credibility, but it is not clear that the answer is to raise interest rates sooner and further. Our model suggests that in order for the MPC to reach its CPI target by 2013, early and rapid rate rises would be required. This could push the UK economy back into recession at the end of 2012.
In addition, as was argued in Saturday's FT, a rate rise would not only threaten a recession but it could be counterproductive. “High prices are the best incentive for investment to remove supply bottlenecks. Damping them slows the self-correcting mechanism.”
Rising prices and inflation are a concern, and do pose a threat to the MPC's credibility. But for now, given the fact that much of the current high inflation is externally driven, the MPC's “wait and see” approach is probably the right one. Pre-emptive rate rises could be more likely to damage growth than mitigate inflation.
1 If we start seeing interest rate rises elsewhere then this could cause sterling to depreciate further and put pressure on inflation. This would be a stronger case for a rate rise. Given that our major trading partners in Europe and the US have less of an inflation problem than the UK, and have expressed that they are unlikely to raise rates, this is unlikely to be an issue in the near future.
2 the scenario assumed commodity prices rises at a similar pace to that in 2008 over the next few years, and oil prices rising steadily to around $110 per barrel by the end of 2012

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