BELIEVE it or not the European Central Bank did the right thing yesterday by cutting interest rates. In Britain, Bank base rates should be going up by now; in the US, quantitative easing needs to be tapered; in the Eurozone, however, monetary policy should be loosened. The three economies couldn’t be more different. Hawks are right when it comes to Britain and America – but the doves are right when it comes to the Eurozone, which remains in deep trouble and requires a very different medicine.
Sadly, the ECB’s job is actually impossible – there can be no rational monetary policy for the whole of the Eurozone and its one size fits all interest rates since 1999 have been an utter unmitigated disaster – but it needs to follow the motions. With inflation down to just 0.7 per cent, and many periphery economies still in deep trouble, that means at the very least cutting interest rates. Needless to say, this will anger many Germans: inflation over there is currently 1.6 per cent, a level that many are already uncomfortable with given their understandable, long-standing preference for sound money.
There are lots of ways of assessing monetary policy. Let’s take the simplest first: consumer price inflation. On that measure, the UK has been performing abysmally. We have the highest consumer price inflation at 2.7 per cent of any European Union member state and the Bank of England has missed its target for 46 months in a row. On the retail price index measure, inflation is even higher at 3.3 per cent.
Sure, oil prices are falling, and petrol prices are coming down, great news to consumers and a trend which will help reduce measured inflation. But given the UK’s appalling record on inflation, the fact that growth is bouncing back and the likelihood that employment will continue to grow, our current ultra low rates are looking increasingly absurd and out of date. If I’m right and there is actually much less usable spare capacity in the economy than most economists believe, it is time to tear up the Bank of England’s forward guidance.
By contrast, inflation in the Eurozone has collapsed. It was 2.5 per cent a year ago; it is just 0.7 per cent today. The region could soon face the wrong sort of deflation – in other words, average price drops caused by insufficient aggregate demand, rather than caused by soaring productivity or positive supply-side shocks. On that basis, the Eurozone’s monetary policy should be loosened.
An alternative, more complex tool to gauge monetary policy is the Taylor Rule: it looks at actual versus targeted levels of inflation and actual GDP versus potential GDP. Societe Generale’s Kit Juckes has applied the Taylor rule to the US, Eurozone, Japan and UK. He finds that interest rates in the US are slightly too low but that they are far too high in the Eurozone (where they ought to be, if such a thing were possible, at -2 per cent) and in Japan (where -1 per cent would be appropriate). Given that negative interest rates aren’t usually seen to be possible, the answer, according to this rule, would be lots more QE. What of the UK? Here the story is very different. Our monetary policy is far too loose and has been so since 2009. The Taylor rule suggests that rates should now be about 2.5 per cent, according to the SocGen analysis. This is a very important finding which the Bank of England should study.
Some economists believe that the rate of growth of nominal GDP is what matters. In the case of the UK, my guess is that we will be seeing growth of at least five per cent on that measure over the next few quarters. There is no real agreement as to what the ideal target rate should be – but to me this approach reinforces all of the previous conclusions. When it comes to the UK, the hawks are right – but the ECB did well to listen to the doves.