OTHER things being equal, is it better if interest rates are as far below inflation as feasible, or as high above? Most discussions of interest rates assume that lower interest rates are the better. We are told, in an optimistic tone, that “the Bank of England may be able to keep interest rates at 0.5 per cent for another three years”, but sometimes that “the Bank of England may be forced to raise rates as early as next year”, as if a rate rise would be a terrible thing.
Yesterday, as official statistics showed the UK’s unemployment rate falling more rapidly than expected, and the Bank of England’s Inflation Report upgraded the Bank’s growth forecasts, Reuters stated gloomily that the “Bank of England sees risk unemployment could hit 7 per cent by end of 2014”. We would meet Mark Carney’s “forward guidance” marker for considering an interest rate rise nearly two years earlier than the Bank had previously thought.
But fear not, for Carney, now driven to offer forward guidance in interpreting his forward guidance, clarified that he could imagine unemployment falling below 7 per cent, but interest rates still not being raised for some time. Phew! We wouldn’t want rates to rise, now, would we?
Where does this notion come from – that the ideal is for interest rates to be as low as possible for as long as possible? For a given inflation rate, lower interest rates mean borrowers gain at the expense of savers. Why would we want that? Low rates mean that, to the extent that labour and capital are substitutes rather than complements (which for our purposes, we can take as meaning “for a given level of GDP”), firms will tend to prefer to substitute capital in place of labour. Is that a good thing? Low rates also mean that firms that have become fundamentally unproductive can linger on for longer before they finally die off, so the cycle of new firm entry and new product innovation becomes slower. Is that desirable?
There is a famous economic argument (famous, but not believed by anyone) that it is ideal to have a bit of deflation and about-zero interest rates. There is no established argument, however, that it is ideal to have inflation of 3 to 5 per cent and zero interest rates, which has been the UK’s situation for most of the past few years. Zero interest rates had value as a temporary necessity in 2009 to 2011, as recession came and financial collapse beckoned. But policy should not be seeking to retain low rates as long as possible. Instead, it should be seeking to normalise rates – back to a healthy equilibrium, in which interest rates are 1 to 3 per cent above the inflation target, so around 3 to 5 per cent – as quickly as feasible.
“As quickly as feasible” does not, of course, mean we raise them to 5 per cent tomorrow. But the Bank should be seeking every opportunity, every excuse, to edge rates up. Instead, it is seeking every excuse to promise it will keep them low for longer and longer. That attitude will retard truly sustainable recovery, and risks eventual high inflation and interest rates spikes. We should be challenging the Bank more upon its rationale for this approach.
Andrew Lilico is chairman of Europe Economics.