Policy Research in Macroeconomics

The Bank of England should not raise rates: here’s why

This week a friend casually explained that he and his wife considered having a second child. But having recently moved into a new house, they were having to fork out a large share of their income on mortgage interest payments. Hearing talk of potential rate rises had therefore persuaded them not to risk another pregnancy.

Such are the life-changing impacts of decisions (or non-decisions) made by a group of men (and one woman) on the Monetary Policy Committee (MPC) of the Bank of England.

That morning the BBC had asked me to participate the next day in their 6.15 a.m. Business slot on Radio 4’s Today programme. The reason, the producer explained, was my known opposition to further Bank Rate rises. As I prepared to make the case that evening, Chris Giles of the FT tweeted that Mark Carney, governor of the Bank of England, had flip-flopped on the question of a rate rise.

“Financial markets” he was quoted as saying (were) “wrong to assume a UK interest rate rise in May is a foregone conclusion as softer economic data are giving the Bank of England pause for thought.”

This announcement came as a surprise to those active in foreign exchange markets (where sterling was promptly marked down). It should not have come as a surprise to anyone examining the latest British economic data.

First, let us consider wages growth, of concern not just to employees, but to the MPC whose primary “Monetary Policy Objective is to maintain price stability within the United Kingdom..”  In its latest Inflation Report (published in February) the Bank’s staff assert that 

“The cost of labour, and in particular wages, is the largest domestic cost facing most companies and hence is a significant driver of domestic inflationary pressures. The degree to which those costs affect in inflation will depend on growth in unit labour costs (ULCs) — the labour costs associated with producing a unit of output.”

Note that nominal wage growth before the Great Financial Crisis averaged around 4%. But that was then. Real wages have fallen in seven of the nine years since the global recession, and the OBR expects them to fall again in 2018. These are the numbers that explain Britain’s cost of living crisis.  If we compare today’s average real weekly wage to that of 10 years ago, then on an annual basis, British workers are £880 worse off than they were in 2008. If comparisons are made between wages for the peak month of February 2008, and the same month in 2018 – then workers are £1800 worse off today than they were then. When the Coalition Government took office in May, 2010 real pay was £493 a week. Now almost eight years later it is £486 a week.

But back to today’s data. For nominal wages the rolling three-month average rose at 2.8% – a tiny fraction above inflation. But in February – the latest month of data for wages – the rate slipped back to 2.3% in the private sector. The only sectors that are doing materially better are ‘Finance & Business’ where on a rolling three-month basis, wages are rising by 3.5%. But even for this sector wages fell to 3% in February.  For the low-paid – workers in retail and hotels – wages in February rose by a meagre 1.7%, and the three-month rolling average by 2%.

Given that the Bank of England believes that “the cost of labour, and in particular wages… is a significant driver of domestic inflationary pressures” – we can rightly assume that because wage rises are diminishing, these pressures are benign or dormant. The Bank’s Inflation Report researchers certainly think so: in February they expected inflation to be 2.9% in 2018 Q1, and then to fall back to 2.6% by Q4.  The OECD agrees: “inflation is projected to remain moderate in the major economies” argued its staff in a November report.

And then the ONS published the Consumer Prices Index – and reported that the 12-month inflation rate had fallen to 2.3% in March 2018, down from 2.5% in February 2018.

Economists are now challenged by a range of ‘puzzles’. In addition to the long-standing ‘productivity puzzle’ there are now two more: a ‘falling inflation puzzle’ and a ‘falling wages’ puzzle. Why is inflation falling? And given that unemployment is low, why are real wages still low and in some cases, falling? Economists do not know the answers to these questions.

Policy makers have long believed that if unemployment falls below a certain point, then wage inflation will begin to rise and that this point represents a so called ‘natural’ rate of unemployment (more specifically the non-accelerating inflation rate of unemployment (NAIRU). But unemployment and real wages have fallen together! And still there is no sign of inflation rising.  Levels of employment are as full as Britain has had since 1975. Unemployment has been below 5% the last 18 consecutive months.  And yet pay in February did not rise: instead, as noted above, it slipped back to 2.3%.

There should be no puzzle. Common sense tells us why wages are low. Thanks to attacks on trades unions and on the power of workers to collectively negotiate wages, employers are today far more powerful than they were before the 1984-5 Miners’ Strike. They are now in the position that Mrs Thatcher and her government fought for and can dictate low and falling wages. Joan Robinson, a distinguished Keynesian economist, identified this one-sided market power way back in 1933. She defined it as monopsony in her book The Economics of Imperfect Competition.  In the absence of effective bargaining powers for workers, employers can now command wage rates.

While this may be a profitable strategy for individual firms and their shareholders, it is dangerous for an increasingly fragile British economy. 

One of the reasons is this: thanks to low and falling wages, there is no growth in spending. Retail sales are down in volume terms, because of the impact of the depreciation of sterling, and the rise in import prices. Higher prices meant that spending in the retail sector is unchanged from the year before.  And as Reuters reports, “British shoppers stayed home in March as they felt the chill from the ‘Beast from the East’, leading to the biggest quarterly fall in retail sales in a year.”

Yet another danger lies in the growth of UK household consumer credit, which, according to the Bank of England grew 9.3% over the last year – no doubt to compensate for low or falling real wages. The FCA explains that “1 in 5 mortgages today are interest only mortgages, many of which were made at the height of the credit boom to borrowers with little equity in their homes and not a lot of disposable income. And they won’t mature until about 2032.”  Total credit lending to individuals is currently very close to its September 2008 peak  – according to the FCA.  And we know what happened then.

“There are a significant number of households that are in so deep that the slightest sign of rough weather could see them in over their heads,” said Jonathan Davidson, one of the FCA’s directors of supervision.

Given these imbalances, the biggest danger facing the British economy is this: at their meeting in May the Monetary Policy Committee of the Bank of England is very likely to raise rates – despite a warning from the governor – because of the ongoing fear of inflation.  (Andrew Sentence, an ex-MPC member tweeted this week that it is “Quite likely that all 4 external #MPC members will vote for a May rate rise. Can they get 1 or 2 internal votes to support them? If Carney is opposed, Broadbent and Haldane are main candidates to push through a rate rise – so watch their statements in the next week or so.”)

If Andrew Sentence is right, MPC members will raise the Bank Rate despite the dangers listed above – and after signs of instability and volatility in the global economy. (Several of the many bubbles in the ‘frothy’ global economy recently burst, including Bitcoin which at the end of 2017 traded at nearly $20,000 and then collapsed to less than half the value at its peak. The recent short-selling of the Volatility Index on Wall St. caused major losses to what are known as Exchange Traded Funds. And there are several other financial bubbles at risk of implosion – including the bubble in corporate debt; the valuations of FAANGs (Facebook, Amazon, Apple, Netflix and Google) and the bubble in Tech stocks.)

Ten years after the Global Financial Crisis, little has been done to restructure the flawed international and domestic financial system. Global imbalances (in trade, exchange rates and the financial sector) and domestic imbalances (including inequality) have intensified, not diminished. It is as if we have learnt nothing from the crisis. As a result, both the global and the British economy remain fragile.

Raising Bank of England rates at this point of fragility, would be like deliberately and repeatedly pointing a sharp dagger at a bubble of household, corporate and financial debt.

It might even cause birth rates to fall, as parents like my friend prioritise higher interest payments on their mortgage – over hopes for another child


One Response

  1. I could not disagree more. The official interest rates set by the Bank of England, and other central banks do not determine the actual market rates of interest, which are determined by the demand and supply of money-capital. Nor, therefore, does action of printing money, QE, as opposed to the creation of additional money-capital (from increased realised profits, or the mobilisation of additional savings for productive investment [primary accumulation]) act to increase the supply of money-capital, as David Hume, Massey and others showed more than 2 centuries ago. Printing more money simply changes the unit of measure by an equal amount on both sides of the demand-supply equation, by devaluing the currency unit, and so has not effect on the central pivot point, between them, i.e. the rate of interest.

    But, what the manipulation of the official interest rate, and the use of money printing DOES do is to raise the prices of those financial assets that the Bank chooses to buy, i.e. government bonds, and in cases some commercial bonds, and mortgage bonds. In an economy where yields on financial assets have already fallen to low levels, where speculators are concerned with is no longer yield, but the acquisition of large capital gains from these rises in asset prices.

    What it also thereby does, is to drain money from general circulation, and potential money-capital from real productive investment, into speculation in these financial assets, land and property, because they have become detached from the real economy. A look at the fact that the Dow Jones rose 7 times as much as US GDP between 1980 and 2000, or its almost quadrupling since 2009, or a look at the astronomical rise in property prices, many of which are left empty and unrented, because the speculators that own them are more interested in capital gain than rent, illustrates the point.

    Capital that could have gone into productive investment, and led to higher levels of employment and growth, is instead diverted, by the action of the central bank into financial and property speculation. Many people cannot afford to buy a house, because the central banks have inflated property prices to such a level that even with rock bottom mortgage rates, the cost is too high, which is why we have seen home ownership rates drop, and why existing home owners cannot afford to move up to a better house.

    The astronomically inflated house prices and pushing of people thereby into renting, which then pushes up rents. With the UK’s low productivity (due to a lack of productive investment, central bank action has encouraged money-capital into financial speculation) and low wages, workers can’t afford to pay these high rents, and so Housing Benefit has soared. That comes out of taxes, which again comes out of profits, which means that even more potential money-capital that could have gone into productive investment goes instead to unproductive landlords.

    The same is true with the cost of pension provision. By massively inflating asset prices, central banks have made it far more costly to provide for pensions. As share and bond prices have soared, every £1 of pension contribution paid into pension funds by workers and employers each month buys fewer and fewer bonds and shares. In the end, it is the quantity of these shares and bonds that determines how much revenue the pension fund obtains, and it is again ultimately that revenue not the paper capital value of the fund, which determines its ability to pay pensions.

    For 40 years, the price of shares and bonds has continued to rise, so that the cost of providing pensions has continued to rise. But workers were not given higher wages so as to cover the higher cost of the shares and bonds they needed to buy to go into their pension fund, and employers often used the illusion of the inflation of the nominal value of the fund to argue that ridiculously that there was enough money in the fund, because they could somehow continue to pay out pensions for ever from the ever inflating nominal value of the fund! They couldn’t so pension funds developed huge black holes, and workers found their pension funds were useless.

    We need to stop bailing out the financial and property speculators with low official interest rates, and QE, and start ensuring that available money-capital goes into real capital accumulation. A look at the 4000% rates of interest charged by the payday lenders shows what happens when central banks rig the market so as to provide artificial incentives for money-capital to go into such speculation and away from the real economy.
    Nearly all bank lending goes to property speculation of some sort, with only about 4% going to business lending. The big companies can issue their own commercial bonds, often themselves bought by central and commercial banks, but the smaller firms cannot, which is why unable to borrow from the bank they have had to resort to far more expensive forms of credit, including the use of credit cards

    If we want to have the economy grow, its necessary to burst the huge serial speculative bubbles in financial and property markets, thereby reduce the cost of shelter, and price of land (which is itself a massive constraint on the profitability of new house building) reduce the cost of workers pensions, and thereby facilitate money-capital going back into productive investment.

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