UK Lending rate
With prominent members of the Bank of England’s monetary policy committee (MPC) – not least the governor – lining up in recent weeks to talk up the prospect of rate rises at some point in the coming months, this week’s meeting has already sparked another burst of speculation about when the first hike in eight years will happen.
Whatever your take on the exact timings of monetary lift-off – whether you’d opt for August or April – the far more important issue is the medium-term path of increases that follow.
And the nature of that path depends on all manner of things – not least George Osborne’s fiscal plan.
This is, of course, a statement of the screamingly obvious. It’s hardly news that what the Treasury does affects Threadneedle Street and vice versa. Which is why it is surprising that the overall mix of monetary and fiscal policy – and how the two interact – is so rarely put under the spotlight.
Economic commentary tends to oscillate between focused bouts of fiscal and monetary scrutiny. But the balance between the two? Not so much.
The Bank takes account of the fiscal policy being set across town (welcome to the “monetary reaction function”). In seeking stable inflation, and in order to underpin growth, the theory is that the Bank conditions its monetary stance to take account of the chancellor’s fiscal choices. But external scrutiny of this policy interaction – assessments of whether the right balance has been struck – are hindered by a lack of transparency about these assumptions.
In 2018 – by when, bear in mind, most of the work of austerity is expected to have been done – Miles calculates that fiscal consolidation will still drag interest rates downwards by more than 0.75% compared to what would otherwise be the case.
This is one of the factors explaining the (commonly held) assumption that interest rates will approach a “new normal” over the next few years that is likely to be about half as high as the 5% that prevailed pre-financial crisis. Even in the second half of the parliament this “fiscal headwind” will still be blowing strong.
Some caveats are needed. Miles was at pains to stress that these estimates are his own, not official Bank figures. Nor is it clear what the basis for this calculation is: is the counterfactual no austerity at all? What assumption is made about sterling?
We should also note that the Miles figure differs from other calculations in the public domain. When the National Institute of Economic and Social Research (NIESR) looked at the interaction between the parties’ differing fiscal plans and interest rates it estimated that the Labour and Liberal Democrat fiscal plans would raise the base rate by 0.7 percentage points; whereas Conservative plans would raise them by 0.3 percentage points.
In other words, the extra tightening associated with achieving an overall surplus (Conservative) rather than a current budget one (Labour/Lib Dems) created a 0.4 percentage point drag on interest rates.
The case for introducing more transparency isn’t mere technocratic trimming. The balance struck between monetary and fiscal policy has big consequences. There are obvious distributional implications (all else equal, mortgage holders win; savers lose).
There are ramifications too for the capital allocation process, the current account, and the risk of an asset-bubble. The list goes on: the macro-mix matters.
Above all better public understanding of the trade-offs between fiscal and monetary policy will help inform a key macro-policy dilemma of our times.
It’s quite likely that we are now closer to the next recession than we are to the financial crisis. And as things stand we are utterly ill-prepared: rockbottom interest rates and high levels of public debt leave us with few (conventional) policy tools. Creating more space for monetary policy to react to a future downturn is vital. Yet doing so precipitously would be hugely counterproductive, risking the very recession that we are seeking to avoid.
Monetary and fiscal policy matter greatly in their own right. Looked at in isolation we have robust institutions in place to hold policy-makers to account – far more so than was the case prior to the Bank gaining its independence and the creation of the OBR. But scrutiny of the overall macroeconomic policy mix? In some ways that’s become more opaque since policy responsibility bifurcated.
Securing the right blend of policy over the medium term is what we should be focused on. That requires more visibility of how policy makers think monetary and fiscal policy interact.