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.

Start your day with The Independent, sign up for daily news emails
ebooks
ebooksAn introduction to the ground rules of British democracy
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
SPONSORED FEATURES
Independent Dating
and  

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

iJobs Job Widget
iJobs Money & Business

Guru Careers: Tax Manager / Accountant

£35 - £50k DOE: Guru Careers: A Tax Manager / Accountant (ACA / CA / CTA) is n...

Ashdown Group: Contracts Executive - City of London

£35000 - £37000 per annum + benefits: Ashdown Group: Contracts Executive - Cit...

SThree: Trainee Recruitment Consultant

£20000 - £25000 per annum + OTE £45K: SThree: SThree Group have been well esta...

Recruitment Genius: Call Centre Debt Collector - Multiple Roles

£21000 per annum: Recruitment Genius: This is an exciting opportunity to join ...

Day In a Page

Giants Club: After wholesale butchery of Idi Amin's regime, Uganda’s giants flourish once again

Uganda's giants are flourishing once again

After the wholesale butchery of Idi Amin's regime, elephant populations are finally recovering
The London: After 350 years, the riddle of Britain's exploding fleet is finally solved

After 350 years, the riddle of Britain's exploding fleet is finally solved

Archaeologists will recover a crucial item from the wreck of the London which could help shed more light on what happened in the vessel's final seconds
Airbus has patented a jet that could fly from London to New York in one hour

Airbus has patented a jet that could fly from London to New York in one hour

The invention involves turbojets and ramjets - a type of jet engine - and a rocket motor
10 best sun creams for kids

10 best sun creams for kids

Protect delicate and sensitive skin with products specially formulated for little ones
Tate Sensorium: New exhibition at Tate Britain invites art lovers to taste, smell and hear art

Tate Sensorium

New exhibition at Tate Britain invites art lovers to taste, smell and hear art
Ashes 2015: Nice guy Steven Finn is making up for lost time – and quickly

Nice guy Finn is making up for lost time – and quickly

He was man-of-the-match in the third Test following his recall to the England side
Ashes 2015: Remember Ashton Agar? The No 11 that nearly toppled England

Remember Ashton Agar?

The No 11 that nearly toppled England
Turkey-Kurdish conflict: Obama's deal with Ankara is a betrayal of Syrian Kurds and may not even weaken Isis

US betrayal of old ally brings limited reward

Since the accord, the Turks have only waged war on Kurds while no US bomber has used Incirlik airbase, says Patrick Cockburn
VIPs gather for opening of second Suez Canal - but doubts linger over security

'A gift from Egypt to the rest of the world'

VIPs gather for opening of second Suez Canal - but is it really needed?
Jeremy Corbyn dresses abysmally. That's a great thing because it's genuine

Jeremy Corbyn dresses abysmally. That's a great thing because it's genuine

Fashion editor, Alexander Fury, applauds a man who clearly has more important things on his mind
The male menopause and intimations of mortality

Aches, pains and an inkling of mortality

So the male menopause is real, they say, but what would the Victorians, 'old' at 30, think of that, asks DJ Taylor
Man Booker Prize 2015: Anna Smaill - How can I possibly be on the list with these writers I have idolised?

'How can I possibly be on the list with these writers I have idolised?'

Man Booker Prize nominee Anna Smaill on the rise of Kiwi lit
Bettany Hughes interview: The historian on how Socrates would have solved Greece's problems

Bettany Hughes interview

The historian on how Socrates would have solved Greece's problems
Art of the state: Pyongyang propaganda posters to be exhibited in China

Art of the state

Pyongyang propaganda posters to be exhibited in China
Mildreds and Vanilla Black have given vegetarian food a makeover in new cookbooks

Vegetarian food gets a makeover

Long-time vegetarian Holly Williams tries to recreate some of the inventive recipes in Mildreds and Vanilla Black's new cookbooks