Monday, July 26, 2010

How Long Will Interest Rates stay at Zero?

Already, one member of the MPC, Mr Sentance, has voted for an increase in interest rates. Mr Sentance argued for a rise in rates from 0.5% to 0.75%. His logic is that inflation is in danger of becoming normalised at above target. Also, if rates are left too low for too long, when they rise sharply it may create a destabilising effect, as suddenly people are faced with higher mortgage payments e.t.c. It is better to raise interest rates gradually and pre-empt the need to raise them radically later.

The Office for Budget Responsibility expects interest rates to rise in 2011, reaching 3% in 2014.

However, a new forecast for Ernst & Young Item club states that it feels interest rates could stay at 0.5% until 2014. (link E Y)

On the hand we have unexpectedly high inflation. CPI 3.1% - part of this is due to cost push factors - oil prices, VAT increases, impact of weaker pound. But, also there is evidence that unemployment and spare capacity in the economy are having less downward pressure on interest rates than expected. Expectations of inflation are increasing and this may mean inflation becomes permanently anchored at a higher rate.

On the other hand, we have a weak economic recovery. Unemployment is at a ten year high. Output is now far below its trend rate potential (rough estimates of 6% of GDP). Furthermore, the government is planning a significant tightening of fiscal policy to reduce the budget deficit. This combination of public sector job losses, wage freezes, spending cuts, will all reduce economic growth and exert downward pressure on inflation in the medium term.

Given there are few alternatives to tackling the UK deficit at some stage, it is necessary to rely on a loose monetary policy to maintain growth.

If we have a combination of fiscal tightening and higher interest rates, the economy may struggle to grow at a trend rate sufficient to make a dent in unemployment.

In such a scenario higher interest rates and fiscal austerity may have the paradoxical effect of failing to improve the UK's budget deficit. As Ireland found out last week - sweeping spending cuts can still lead to a credit rating downgrade. Ireland's credit rating was downgraded because its GDP fell 6% (partly as a result of austerity) and the forecast for growth in Ireland is for it to remain well below trend (Moody downgrades Irish debt at BBC). If fiscal tightening causes negative growth, there can be a worsening of tax revenues and cyclical deficits, which negates some or all of the austerity cuts.

Predicting interest rates into 2014 is very difficult, given so many different things could occur. In the short term, the UK faces a serious challenge to its fragile growth. Despite the limitations of a zero interest rate policy, there is a high cost in raising rates at the same time as other props are being removed. The MPC seem to have weighed up the relative importance of inflation and growth, and so have not been too distracted by the current inflation spike. If this continues, I feel interest rates will continue to stay low.

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