It’s that time of the month again today. Once more, the men and women who sit on the Bank of England Monetary Policy Committee will decide upon the rate of interest for another month. Most expect rates to stay on hold, they probably will, but behind the scenes it seems that, this time, the MPC faces a massive dilemma.
The reasons for a cut in interest rates are overwhelming. The trouble is, so are the reasons for not cutting rates. Which side in this battle of hawks and doves will eventually win?
Here are some of the arguments for: First argument relates to the money markets. Usually, when markets expect rates to fall, then the three month interbank (LIBOR) falls below the official bank rate, as markets start discounting for future falls.
Yet, when the Bank of England lowered rates to 5.25 per cent last month, the LIBOR rate did something odd – it went up, and is now 50 basis points above the official rate, at around 5.75 per cent.
Why is this? It seems at least part of the explanation lies with banks’ concerns about credit risks. Sure, the recent fears over monoline insurance may be a factor, but above all, it seems they are just worried, and want to hold more cash.
In other words, the Bank of England may want to see interest rates fall, but the markets are not obliging – so the BofE may conclude it needs both to lower interest rates some more, and change liquidity requirements for the banks, and perhaps pump more money into the system, just to get money market rates at the level it wants.
Of course, with the housing market apparently on the edge, with various evidence suggesting our disposable income has barely changed now for several years, and with many fearing a recession could be around the corner, a cut in interest rates, which was then adopted by the markets, would help to kick-start the economy.
It’s not that a cut in rates would merely encourage further borrowing, maybe in an economy as indebted as ours that would be a bad thing, but it wants to make debt cheaper for those already with higher borrowings. That would help lift the feeling of gloom.
But what about inflation? Is there not a risk that lower rates would stoke up inflationary pressures even further. And this takes us to the really interesting aspect of the debate.
Inflation is set to rise – that is clear. The Bank of England may well find the CPI index will rise by more than a full percentage point above inflation soon, forcing it to write another letter to the chancellor. But, the key is not so much what will happen in the next few months, when we know prices will go up, but what will happen beyond that.
You need to bear in mind, increases in prices are not the same thing as inflation. Inflation is a sustained rise in prices, and this usually only occurs when demand is higher than supply. The key for predicting inflation is said to be whether there are second-round effects – whether, for example, wages increase in response to higher wages. At the moment, this is not happening.
The central banks, goes the argument, have no control over the price of oil and food; to increase rates because inflation is pushed up by forces it has no influence over, would be foolhardy.
The US could be on the verge of recession, the UK may follow; this means demand will fall, ergo inflation will fall too. Right now, goes the argument, we are merely experiencing an inevitable time lag as inflation reacts only slowly to changes in the economy.
Think of it this way. You are having a shower in a bathroom you are unfamiliar with. Someone else in the house turns on a cold tap, before realising you were in the shower, and then turns it off. This reduces the supply of cold water in your shower for a few seconds. You don’t realize this, and so you turn your cold tap up. In a few seconds you will experience a double hit. The shower will simultaneously respond to you turning up the cold tap, just as it was cooling down anyway. Brace yourself, for now, the water is ice cold.
The danger is that if central banks respond to inflation cost pressures, they will leave rates high, just at a time when inflation was about to dip anyway. This could then lead to a crash in asset prices – and the big fear, the West will see a repeat of the Japanese experience – ten years of economic malaise. Or, as it is sometimes called, the lost decade.
So, you see, it is very important central banks get the call right.
But here is the flip side of the coin. Demand, especially in the US and UK, is far too high. Saving has not been anywhere near high enough. Usually, inflation would have set in, but thanks to other external factors, such as the Internet promoting price competition, and cheap imports from China, inflation has stayed modest.
So, while it might be argued that the factors that are currently leading to inflation are one-offs, so too are the factors that led to low inflation.
But are these factors one-offs? Oil is high, because demand for oil is high. This has led to a rise in the use of biofuels – as alternatives to oil. At the same time, the world’s consumers are demanding more food products – especially meat – which has led to a sharp rise in demand for wheat. And by the way, growing crops to feed animals to produce meat is not efficient, we get far more from the land if it is used to grow food we eat directly. So the move towards greater consumption of meat is, perversely, leading to greater demand for agricultural crops such as wheat.
This argument would suggest that the recent rise in inflation across the world is, after all, down to growing demand.
Until recently, consumers in the West were spending heavily, while in China, Japan and the oil-exporting countries, saving was even greater. This means that overall, saving was greater than demand, hence low global inflation.
There is a danger this has changed. And what this means is that in the West, we can no longer afford to borrow our way into consumer-led growth. If we do, inflation will occur.
Returning to that shower analogy. Sure, someone somewhere else in the house has just turned a cold tap on, making your shower too hot, but only for a short while. But, supposing someone else in the house had left a hot tap running for some time, and they are about to turn it off.
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