THE RISKS OF RAISING INTEREST RATES TOO QUICKLY / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( VERY HIGHLY RECOMMENDED READING )

The risks of raising interest rates too quickly

By Martin Wolf

Published: January 13 2011 21:59

To tighten or not to tighten, that is the question. It is one on which the current UK discussion risks becoming more than a bit hysterical. Yes, inflation is well above target. Yes, the Bank of England failed to forecast this. Yet these facts are neither a necessary nor a sufficient argument for tightening policy.


Famously, monetary policy works with long and variable lags. No sane monetary policy – that is, no policy that seeks to avoid the certainty of futile slumps – could prevent an overshoot of the target over the next few months or even over the next year. These are just bygones. All anyone can do over bygones is weep.
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The question, however, is whether this overshooting might continue. The answer? Probably not. According to the Treasury, the latest average forecast for growth of gross domestic product in 2011 is 1.9 per cent. The latest forecast from the Organisation for Economic Co-operation and Development is for growth of final domestic demand of a mere 1.2 per cent.


All such forecasts are highly uncertain. But these hardly suggest excess growth of the economy. Monetarists may note that broad money (M4) grew by just 2 per cent in the year to the third quarter of 2010. Keynesians can add that a huge fiscal tightening is now under way.
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More important, even on gloomy assumptions, substantial slack should remain. The OECD predicts the UK’s output gap – the difference between actual and potential GDP, as a share of the latter – at 4 per cent in 2011. Unemployment has remained stuck at close to 8 per cent of the labour force since the middle of 2009. Arguably most important of all, unit labour costs rose only 1.5 per cent in the year to the third quarter of 2010, while average earnings rose by 2.1 per cent.
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We can, in short, see no sign of an incipient wage-price spiral. Nor does one seem imminent. Expectations implicit in gaps between yields on conventional and index-linked government bonds are volatile. But they are currently at about 3 per cent. This is slightly below their average of the past six years.


In short, I concur with a speech last month by Adam Posen, a member of the Bank’s monetary policy committee: the experience of countries that have suffered from financial crises, overhangs of private sector debt, high unemployment and sharp fiscal tightening suggests that UK inflation is far more likely to undershoot the government’s target than overshoot it, two years hence.


True, continued rapid rises in import prices might mean another overshoot of the inflation target, in spite of past experience. But should the Bank tighten now in response to a possible overshoot of its target two years from now driven by further rapid rises in the prices of imports?


The answer should be “no”.


First, it is impossible to predict the direction of the more volatile world prices. Moreover, sterling’s external value is also just as impossible to forecast. Even the link between interest rates and the currency’s value is highly uncertain. True, the government’s chosen measure of inflation includes externally driven prices. Yet, given the uncertainty about their likely evolution, it makes far more sense to focus on domestic costs, ignoring any one-off tax hikes.


Second, it makes next to no sense, in any case, to raise unemployment, in order to drive down wage inflation even further, with a view to offsetting the inflationary impact of something inherently uncontrollable.


This last point can be made more concretely. Suppose that two years ago, in the depths of the post-Lehman slump, the Bank had correctly forecast the future adverse trend of headline inflation (which, as we all now know, it did not). Assume, in short, that the MPC correctly understood the impact of the fall in sterling, of movements in commodity prices, and of changes in tax policy on today’s inflation. Do people calling for higher rates now – in spite of the absence of any domestic inflationary pressure from either demand or supply – believe that rates should have been higher, quantitative easing smaller, or both, in order to increase unemployment even more and so hope to achieve the target rate of inflation today?

I suspect the answer of most would be no, and for good reasons. The case for tightening would have been too uncertain and the costs of tightening all too certain. The same argument applies today. The sensible course is to accommodate the impact of any adverse shocks but act against signs that these are beginning to be embedded in inflation expectations, above all in the labour market.


Yet of such a shift in expectations, we can see next to no sign. To impose large and definite costs now, merely to lower the possibility of a future jump in inflation expectations, would be absurd.

The MPC should fix its eye on what the economic situation suggests underlying inflation might be two years hence. It should ignore current inflation, since it cannot change this outcome. It should certainly ignore the impact of one-off jumps in taxes. It should, above all, act only if it sees clear and present danger of a permanent rise in inflation expectations. Anything else is sado-masochism.


Copyright The Financial Times Limited 2011.