The UK economy has not fallen off a cliff – do we really need a cut in interest rates?

Years of near-zero interest rates, here and elsewhere, have become destructive, and the conventional wisdom of central bankers that the benefits exceed the costs may be quite wrong

Hamish McRae
Wednesday 26 October 2016 19:19 BST
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Mark Carney, Governor of the Bank of England, which may be making a decision on interest rates next week
Mark Carney, Governor of the Bank of England, which may be making a decision on interest rates next week

Tomorrow the UK gets its first GDP figures for the post-Brexit world. They will show that growth has continued in the July/September quarter, though at a somewhat slower rate than in April/June. All in all we look like having 2 per cent growth this year, maybe a little less. But if the economy clearly has not fallen off a cliff, fears that it may (probably will) slow more next year may push the Bank of England’s monetary policy committee into cutting rates next week.

Actually I think it may well not do so, for five reasons. First, if the GDP figures are half decent they would confirm that there is no immediate need for a further boost, if a cut in rates would indeed do that. Second, the fall in sterling has been greater than expected by the Bank and the impact of this fall is already equivalent to a sharp loosening of monetary policy. Third, it is quite plausible that it will push inflation up to more than 3 per cent next year, above the Bank’s target range. Four, a further decline in sterling might start to destabilise the economy by undermining business confidence more generally. And finally, the Bank would be wise to keep something in reserve should things slow suddenly next year.

But behind all this is a wider concern. It is that years of near-zero interest rates, here and elsewhere, have become destructive, and that the conventional wisdom of central bankers that the benefits exceed the costs may be quite wrong.

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This concern pops up in a number of places. There is the blow to savers, noted by Theresa May in her party conference speech. There is the damage to pension funds, whose actuarial capacity to fund pension liabilities is cut by the fall in long-term interest rates. There is the creation of a bond bubble, which at some stage is bound to burst.

But behind all this is the more general issue that this may be one of those times where common sense has gone out of the window: where clever people who are close to the issue have boxed themselves into a set of ideas that are plain wrong.

There have been plenty of examples of this in recent history, some of them well-described in a new book by the economic commentator Tim Harford in Messy – how to be creative and resilient in a tidy-minded world.

One key example is the regulation that led to the banking crisis. Harford explains how the international agreements on how to regulate banks to prevent a global crisis – starting with the Basle Accord in 1988 – actually made matters worse. By trying to grade the risks that the banks might face, they encouraged rating agencies in the US to misclassify the risks, and the authorities in the EU to deem the national debt of its members risk-free. Then they were surprised when the banking system blew up.

Now we have a developed world economy that only seems to be able to grow if interest rates remain close to zero, and even below that in some part of Europe and Japan. Yet here in the UK the economy is growing, unemployment is below 5 per cent, and employment as a percentage of the workforce is the highest ever. Is that an economy that needs near-zero rates?

Much the same argument applies to the US and to Germany. Sure, Japan is struggling to escape from a period of stagnation that has now lasted for a generation, but that has more to do with demography and regulation than interest rates. Yet central banks around world are stuck with the policy, with even the US Federal Reserve hesitating before increasing rates.

Now suppose, just suppose, there were to be an international accord between the main central banks that they would seek over time to return to normal, but low, interest rates. The banks would get together, rather as they did with the Plaza Accord on currencies in 1985, and make a simple announcement that the world no longer needed ultra-cheap money and that the costs were beginning to exceed the benefits. What would that do to the world economy? Would rates of 2 per cent derail the recovery? My guess is they would strengthen it, because investors would grasp that an abnormal period was coming to an end.

Well, we will see what the Bank of England does next week, but my prediction is this: if they do cut rates that will have an adverse impact on the economy, not a positive one.

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