The City has had the date ringed in the diary for months. On Thursday the Bank of England was supposed to raise interest rates, taking them above 0.5% for the first time in almost a decade.
It’s not going to happen. A deluge of weak data over the past month has surprised the Bank. It has badly misread the economy, and not for the first time.
The message had previously been clear. There was a limit to how long inflation above the government’s 2% target could be tolerated at a time when the steady fall in unemployment was likely to lead to stronger wage pressure. The City knew what was meant when the Bank talked about the need for an “ongoing tightening” of policy.
In the past few weeks, however, it has emerged that growth came to a virtual standstill in the first quarter of 2018 and, judging by the first business surveys for April, has not picked up much since. Inflation has come down more quickly than expected. The housing market is dead. Consumers are reluctant to spend. Demand for credit is weak.
The idea that the Bank of England would increase the cost of borrowing in the current circumstances is fanciful. In 21 years of operational independence, the Bank has never cut interest rates when the latest estimate of the quarterly growth rate was below 0.4%.
The financial markets have moved on. They now think the Bank will signal on Thursday that the rate rise has not been abandoned, merely postponed for three months until there is more evidence of the economy recovering and wage pressure building.
The monetary policy committee has a credibility problem though, and anything it says should be taken with a very large pinch of salt. Its inability to forecast the economy accurately undermines its attempts to provide forward guidance over the future path of interest rates.
Any one who thinks the MPC is simply waiting for August to move should recall that the February inflation report said interest rates would need to rise “somewhat earlier and by a somewhat greater extent” than it had anticipated at the end of 2017.
Growth was then expected to come in at 0.3% in the first quarter even after the weather disruption, but it was actually 0.1%. Looking at the data, there is actually a stronger case for interest rates being cut than there is for them being raised.
In part that’s because the government’s fiscal policy – the Treasury’s combination of public spending and tax decisions – is still holding growth back. Philip Hammond eased austerity when he became chancellor, but did not abandon the strategy pursued by his predecessor, George Osborne.
As the National Institute for Economic and Social Research pointed out last week, public spending as a share of GDP has come down from 45.1% in 2009-10 to an estimated 38.9% in 2016-17. But although spending is already below its post-war average of 39.3% of GDP, the Government’s plans further falls to 37.6% by 2022-23. There will be no let up as Hammond pursues his goal of balancing the budget by the middle of the next decade.
In its latest quarterly review, NIESR has used four factors – existing spending commitments, the proportion of the population over 85, the growth rate and the UK’s debt-to-GDP ratio – to estimate the amount of public spending that previous post-war governments would have chosen if confronted by today’s circumstances.
The thinktank calls this “warranted” spending because it reflects the historic choices made by democratically elected governments in the past. Using this approach, it found that the pace of deficit reduction was slower than its estimate of that warranted during the 2010 to 2015 parliament but that since 2014-15 it has been more stringent than it should have been.
Using the same approach to look at individual areas of public spending, the thinktank found that even the NHS – which has had its budget ring-fenced – has been treated too harshly. It estimates that in 2016-17, the health sector needed extra funding of around £440 a head. Spending was also below warranted levels in education, public order and safety and social care. “The government will find it hard to resist pressure to restore the quality of public services in these areas,” NIESR concludes.
A few eyebrows will be raised at the idea that George Osborne’s austerity programme was not tough enough during the years of the coalition government, particularly among economists of a Keynesian bent, but it is hard to dispute the NIESR argument that austerity fatigue has now set in. The public sector is having trouble recruiting staff and voters are starting to fret about the quality of public services.
Hammond says deficit reduction is needed so that the public finances are in decent-enough shape to cope when another recession comes along. Some in the City are urging the Bank to raise interest rates for the same reason.
Self-evidently it would be better to face another downturn with the government in the black and official interest rates at 5% rather than 0.5%, because it would give the Treasury and the Bank more policy space.
But the idea that the MPC needs to raise rates and that Hammond should be cutting public spending – especially when it is so cheap to borrow – in order to stockpile ammunition to deal with the next recession is daft. The point of economic policy is to prevent recessions, not to cause them by tightening policy when it is unnecessary. That’s not prudence. Its self-flagellation.