Sentance is right – he will be missed

Allister Heath
INTEREST rates must rise: that is the message from Andrew Sentance, the distinguished monetary policy committee member, in his exclusive interview in today’s City A.M. (p1 and p13). It is good to see that Sentance, whose principled and intellectually rigorous warnings against inflation have been entirely vindicated, hasn’t changed his mind, despite the fourth quarter’s shock contraction in reported GDP.

To Sentance, the problem is that inflationary expectations could soon become entrenched, leading to a self-fulfilling spiral of higher wages and prices as everyone seeks protection from higher expected costs. Manufacturers are already awarding their staff larger pay hikes, while their input costs are rocketing. If and when the inflationary genie finally comes out of its bottle, the only way to dampen prices down would be much sharper and painful rate hikes than would be necessary today.

I agree with Sentance. The current ultra-low interest rates were designed to cope with an emergency: a near-depression, the possibility of deflation and an implosion of the financial system. These are no longer on the agenda (barring a catastrophe, of course).

The MPC’s refusal to do anything on interest rates, despite a gradual change of mood towards Sentance’s position, is beginning to have a serious effect. Ten-year gilt yields hit their highest level in eight months yesterday: with prices inversely related to yields, investors are now nursing a nasty 1.9 per cent loss so far this year. This performance is the worst of any of Europe’s top economies: there are UK-specific reasons for this bond bloodbath, not least rising inflationary expectations and growing fears that pressure from the Labour party will force the coalition to downgrade its austerity measures.

Yet as yesterday’s strong UK manufacturing survey demonstrates, the economy is rebalancing at last. Manufacturing is booming, thanks to buoyant global demand and a weaker pound; export-orientated services are also bound to recover. Profits are soaring, debt is down and firms are sitting on cash piles. The ratio of sterling bank deposits to sterling bank debt for non-financial companies rose to its highest level since 2005 in December, suggesting imminent corporate-driven investment and job creation.

At the same time, house prices continue to slide, as values fall back into line with earnings. Limited housing transactions, combined with lower prices, suggest construction will remain weak – and this is an area where cuts to the government’s capex programmes will bite. And with real incomes falling thanks to tax hikes and inflation, consumer spending will remain depressed.

We won’t know whether we are out of the woods until Thursday, when the service sector purchasing managers’ index is published. A decent recovery would be a relief; a poor reading a disaster, signalling a double-dip recession. Fortunately, while money supply growth remains weak, it is probably strong enough to underpin a moderate economic expansion.

Sentance’s tour of duty is coming to an end; he will be retiring in May and sorely missed. We must hope that his departure doesn’t delay rate hikes too much. One thing is clear: there has been too much misplaced consensus on the MPC in recent years. Whoever is appointed to fill Sentance’s shoes must be another free-thinker with experience of the real world.
Twitter: @allisterheath