The rise and fall of interest rates

TO TWIST or to stick? The immediate question facing the Bank of England's monetary committee this week is whether to increase UK interest rates another notch, with the evidence for once quite evenly balanced. But behind this decision is a much bigger tale, which is how the UK economy will develop over the next three to five years, both in structural and cyclical terms - questions such as "what might a long period of a strong exchange rate do to manufacturing?" and "will we go into another recession?".

First, the immediate question of interest rates. The background is an economy that has been growing well above its long-term trend and which is showing signs of strain, but which may suddenly be slowing of its own accord. The signs of strain are most obvious in the balance of payments, which was running in surplus for most of last year but started to slither into deficit in the final three months. It has also been evident in earnings, where the annual rise is nudging towards 5 per cent. And it is evident in prices, more in prices of assets (houses, shares) and services than in goods, but a concern none the less.

Against this is a smaller pile of evidence but a lot of worries. There may not be much actual slowing yet, but manufacturers and, in particular , exporters are feeling glum. We know that the East Asian crisis will knock something like half a percentage point off growth this year, and will also exert downward pressure on world prices in general - so there will be deflationary forces from there. And there is a nagging sense of foreboding that at some stage soon even the US economy will turn down, removing an enormous engine of growth from the world.

So had the monetary committee simply been looking at the UK economy, it would probably have little difficulty in concluding that it ought to jack up interest rates a bit further. Its formal remit is to get underlying inflation as close to 2.5 per cent as possible and we are still above that level. Even allowing for the lags between changes of interest rates and the impact on inflation - lags that are long, elastic and uncertain - the prudent thing would be to nudge rates up.

The trouble is that the committee cannot look at the UK economy in isolation, and there are now quite serious risks that the world economy will turn down sharply in the second half of this year. If that is likely, why not allow a slowing world economy to damp down things here?

My guess, for what it is worth, is that the committee will indeed push rates up one more time, but with the understanding that they will be prepared to cut interest rates swiftly if the economy does indeed slow down. How it can get that message across to the markets we will have to see.

But of course in the broad span of world events the decision over a quarter of a percentage point on interest rates by a few people sitting round a table in the Bank of England is not really very stirring stuff. It is the underlying situation of both the British economy and the world economy that makes it interesting.

Have a look at the graph, which shows what has happened to inflation here since the last war. There was, as you can see, a period of post-war disruption as price controls and rationing were dismantled, but the fixed exchange rate system kept inflation under control until 1972. There then was the great 1970s inflation catastrophe, corrected during the early 1980s under the discipline of monetary targets. But when we relaxed those, up shot inflation again, to be controlled first by ERM membership (a fixed exchange rate system again) and then by the present method of inflation targets.

There seem to me to be two powerful messages from this graph. The first is that you have to have an anchor, but any anchor - exchange rate, money supply or inflation - will do. The second is that before 1975 the trend of inflation was clearly up and since then the trend has been equally clearly down.

We are, for the foreseeable future, going to go on having some form of anchor, and I would be surprised (though this is more contentious) if the long-term trend of inflation were not to continue downwards for the next decade, maybe longer.

Lay this long-term perspective on inflation over what seems to be happening to the economy now. What we are seeing is a cyclical boom, which may be about to come to an end, in an era of long-term disinflation. This is a new experience for many people. The boom we most remember, that of the late 1980s, led to a surge in inflation (though nothing like the inflation of the 1970s) because it took place when there was no anchor. The present boom is much more like the booms in the 1950s, when prices were restrained by the need to watch the exchange rate, but even then there was an incipient tendency towards higher inflation. Now there isn't. In fact the present period has more in common with the boom in the south of England during the 1930s when they built all those semi-detached houses along the "arterial" roads.

This has not been a falling-price boom, but we are moving fast in that direction: towards a world in which people get a large part of their rise in living standards through lower prices rather than higher wages.

This will be very, very different from all our past experience. For companies it means becoming accustomed not just to being unable to sustain price increases, but operating in a climate where prices come down, and down, and down. The experience of the airlines (and even more dramatically, the electronics producers) over the past decade will become the norm. I do not know whether sterling's present strength will be sustained for long, though I think it will go on longer than the market at present reckons. But I would advise any company in the export business to work on the assumption that sterling will stay strong because that is the only safe assumption to make.

The result will be continuing, steady, relentless structural change in the economy. Companies in sectors that have been tending to "downsize" will continue to be squeezed and will be surprised (as they are now) at reports that the economy is booming. And companies in expanding areas will find themselves expanding production, but probably not increasing their prices and maybe even reducing them. You can catch a glimpse of this in the economy at the moment: most manufacturing is under pressure and finds it ridiculous that the Bank should be considering putting up interest rates still further; but most services are booming and at least understand the case for higher rates.

Are there bigger cyclical implications for us from the present conundrum at the Bank? Is the next cycle going to be different - bigger, smaller, longer, deeper - than the last?

I don't think it is possible to answer those questions at all yet. The lessons that can be extracted will be more modest. It will be fascinating to see whether the world economy is so integrated that a regional crisis can have a grave global impact: do tails wag dogs? It will be interesting to see how responsive our own economy is to interest rate changes. If, most importantly, rates go up next week and then - come the summer - the economy is going down fast, will a series of cuts in interest rates through the autumn jack up demand fast enough? Will inflationary pressures by then have subsided sufficiently to allow that to happen?

Well, we will have to see what the Bank does decide. The one thing I am sure about, though, is that if they do put rates up they will have to be prepared to cut them sharpish if things head south.

News
A model of a Neanderthal man on display at the National Museum of Prehistory in Dordogne, France
science
News
Richard Dawkins dedicated his book 'The Greatest Show on Earth' to Josh Timonen
newsThat's Richard Dawkins on babies with Down Syndrome
Arts and Entertainment
Eye of the beholder? 'Concrete lasagne' Preston bus station
architectureWhich monstrosities should be nominated for the Dead Prize?
Extras
indybest
PROMOTED VIDEO
News
ebooksAn evocation of the conflict through the eyes of those who lived through it
Travel
Dinosaurs Unleashed at the Eden Project
travel
Arts and Entertainment
music
Sport
football
Life and Style
This month marks the 20th anniversary of the first online sale
techDespite a host of other online auction sites and fierce competition from Amazon, eBay is still the most popular e-commerce site in the UK
News
i100
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Quantitative Analyst (Financial Services, Graduate, SQL, VBA)

£45000 per annum: Harrington Starr: Quantitative Analyst (Financial Services, ...

Application Support Engineer (C++, .NET, VB, Perl, Bash, SQL)

Negotiable: Harrington Starr: Application Support Engineer (C++, .NET, VB, Per...

AIFMD Business Analyst / Consultant - Investment Management

£450 - £600 per day: Harrington Starr: AIFMD Business Analyst / Consultant - I...

Business Analyst Solvency II SME (Pillar 1, 2 & 3) Insurance

£450 - £600 per day: Harrington Starr: Business Analyst Solvency II SME (Pilla...

Day In a Page

Middle East crisis: We know all too much about the cruelty of Isis – but all too little about who they are

We know all too much about the cruelty of Isis – but all too little about who they are

Now Obama has seen the next US reporter to be threatened with beheading, will he blink, asks Robert Fisk
Neanderthals lived alongside humans for centuries, latest study shows

Final resting place of our Neanderthal neighbours revealed

Bones dated to 40,000 years ago show species may have died out in Belgium species co-existed
Scottish independence: The new Scots who hold fate of the UK in their hands

The new Scots who hold fate of the UK in their hands

Scotland’s immigrants are as passionate about the future of their adopted nation as anyone else
Britain's ugliest buildings: Which monstrosities should be nominated for the Dead Prize?

Blight club: Britain's ugliest buildings

Following the architect Cameron Sinclair's introduction of the Dead Prize, an award for ugly buildings, John Rentoul reflects on some of the biggest blots on the UK landscape
eBay's enduring appeal: Online auction site is still the UK's most popular e-commerce retailer

eBay's enduring appeal

The online auction site is still the UK's most popular e-commerce site
Culture Minister Ed Vaizey: ‘lack of ethnic minority and black faces on TV is weird’

'Lack of ethnic minority and black faces on TV is weird'

Culture Minister Ed Vaizey calls for immediate action to address the problem
Artist Olafur Eliasson's latest large-scale works are inspired by the paintings of JMW Turner

Magic circles: Artist Olafur Eliasson

Eliasson's works will go alongside a new exhibition of JMW Turner at Tate Britain. He tells Jay Merrick why the paintings of his hero are ripe for reinvention
Josephine Dickinson: 'A cochlear implant helped me to discover a new world of sound'

Josephine Dickinson: 'How I discovered a new world of sound'

After going deaf as a child, musician and poet Josephine Dickinson made do with a hearing aid for five decades. Then she had a cochlear implant - and everything changed
Greggs Google fail: Was the bakery's response to its logo mishap a stroke of marketing genius?

Greggs gives lesson in crisis management

After a mishap with their logo, high street staple Greggs went viral this week. But, as Simon Usborne discovers, their social media response was anything but half baked
Matthew McConaughey has been singing the praises of bumbags (shame he doesn't know how to wear one)

Matthew McConaughey sings the praises of bumbags

Shame he doesn't know how to wear one. Harriet Walker explains the dos and don'ts of fanny packs
7 best quadcopters and drones

Flying fun: 7 best quadcopters and drones

From state of the art devices with stabilised cameras to mini gadgets that can soar around the home, we take some flying objects for a spin
Joey Barton: ‘I’ve been guilty of getting a bit irate’

Joey Barton: ‘I’ve been guilty of getting a bit irate’

The midfielder returned to the Premier League after two years last weekend. The controversial character had much to discuss after his first game back
Andy Murray: I quit while I’m ahead too often

Andy Murray: I quit while I’m ahead too often

British No 1 knows his consistency as well as his fitness needs working on as he prepares for the US Open after a ‘very, very up and down’ year
Ferguson: In the heartlands of America, a descent into madness

A descent into madness in America's heartlands

David Usborne arrived in Ferguson, Missouri to be greeted by a scene more redolent of Gaza and Afghanistan
BBC’s filming of raid at Sir Cliff’s home ‘may be result of corruption’

BBC faces corruption allegation over its Sir Cliff police raid coverage

Reporter’s relationship with police under scrutiny as DG is summoned by MPs to explain extensive live broadcast of swoop on singer’s home