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W. Peden sent me the following from the British Shadow Monetary Policy Committee:

In its latest email poll, the Shadow Monetary Policy Committee (SMPC) voted to raise Bank Rate by 0.25% in October, the second consecutive month it has voted for an increase. The vote came against the backdrop of the US Fed leaving rates on hold, citing China as one reason. Those voting for a rate hike continue to warn – amongst other things – that in any future economic slowdown, the UK would not have the flexibility to respond by cutting rates if they are not raised soon. One argues that recent data revisions show that there is no negative output gap in the UK, and that is why earnings growth is rising so quickly, a sign that monetary policy is too loose. Those voting for unchanged rates continue to cite little price inflation in the actual data, slow growth in monetary statistics and signs that the economy may be losing momentum.

I don’t know enough about Britain to have an opinion on where they should set rates (although I do have the opinion that they should not target interest rates at all.) But there is one serious flaw in the quote above. And before explaining the flaw, let me point out that it is not one of those debatable issues, like whether QE is a good idea, or whether Switzerland should have abandoned the peg. There’s a basic economic error in this part of the quote:

Those voting for a rate hike continue to warn – amongst other things – that in any future economic slowdown, the UK would not have the flexibility to respond by cutting rates if they are not raised soon.

That’s just wrong. Monetary stimulus does not come from cutting interest rates; it comes from cutting them relative to the Wicksellian natural rate. You can raise rates to 1000% if you want, but then cutting them back to 2% doesn’t make policy expansionary. The problem with raising the target interest rate is that this would reduce the Wicksellian equilibrium rate.

If they are worried about having enough room to stimulate the economy in the next recession, before hitting the zero bound, then they should unquestionably NOT raise interest rates right now. Raising them would reduce the Wicksellian equilibrium rate, and give the BoE less future room to maneuver. Period. End of story. I see this mistake all the time, and I don’t understand why it keeps being made.

Just to be fair and balanced, the other information in the quote does support a rate increase. The rapidly rising wage growth is more important than the inflation, money supply, and real GDP data. So I’m agnostic on the rate question. But please, don’t raise rates to give yourself room to cut them in the future.

PS. Don’t believe me? Check out what the ECB and Riksbank rate increases of 2011 did to their Wicksellian equilibrium interest rates.

PPS. I’ll be at a conference, and thus comment replies will be slow for a few days.

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This entry was posted on October 08th, 2015 and is filed under Monetary Theory, United Kingdom. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or Trackback from your own site.



