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Dear Mervyn
Some commentators are convinced that you will increase interest rates yet again this month. Others argue that the increase it will come later, probably in a month when the Inflation Report is published. Our advice is not just that it would be wrong to increase rates again, because they are already too high, but that you should reduce them. Your duty is to bring British rates into alignment with the rest of the world, and to the lower level now appropriate to the needs of the economy.
We are concerned to find that the widespread expectation that interest rates are now set on an upward path is becoming so firm that it is almost an orthodoxy. The burbling about a `natural rate` - which we know doesn`t exist, shows that the expectation is not grounded on any clear explanation or understanding of why they should rise but rather on simple moralism: credit is too loose; we`re all in debt; house prices are rising too fast, etc. – that`s naughty. It must be punished. None of this is really your business. Nor is there any consensus on why our rates, already so much higher than those of competitors, should be rising further when theirs are not.
Certainly there is no understanding of the effects of high interest rates on the exchange rate or of the prospect that future higher rates, which are now a built in assumption, will have on economic growth and the prospects for production in this country. The whole debate is proceeding on a basis of ignorance, instinct and unjustified assumptions, not the rational analysis and information the MPC was meant to provide. We worry that this is because instinct and assumption are also the basis on which the MPC itself is proceeding. It has been both inarticulate and inadequate in explaining what it is doing.
The reasons given for the recent increases and for the prospect of future increases are based neither on any rational analysis nor on any understanding of what the effects of higher rates are on the economy, but on mysticism. Rises are justified by folk wisdom on the lines of “a stitch in time saves nine” but without any explanation of how or why, or any indication of why increases should be justified by future prospects not present realities of low inflation.
In simple terms you are fighting inflation by putting it up. Hardly logical because it fails to recognise that any increase in interest rates increases the costs of everything. The Bank clearly owes producers and the nation generally an explanation of how putting interest rates up now means lower inflation, not just higher costs later. Just what is the transmission mechanism? How does it work? Doling out bankers` conventional wisdom is hardly helpful. Nor is asking the nation to trust the Bank. The only logical view is that higher interest rates will keep sterling higher than it should be if we are to be competitive, thus forcing producers to reduce labour costs, outsource work, cut costs generally and squeeze everything they can. As a way of managing a sophisticated economy this is sado masochism not any logical system of economics, though there may be another explanation. If so that should be given.
The Bank`s existing explanations give every indication of a fear of growth, indeed a belief that the British economy cannot grow any faster than its present comparatively low rate without disastrous inflationary consequences. Yet we are never told why growth has always to be damped by higher interest rates, unless, of course, there is some unique incapacity in the British economy (or people) which others lack. Perhaps you are, in fact, saying this. If not then the view must be nonsense.
We had higher rates of economic growth in the Fifties and the Sixties, particularly after the 1967 and the Heath devaluations without inflationary consequences. Since then we have endured monetarist reforms to make us more competitive and free the economy of its shackles. It should, therefore, be able to grow faster. At the same time inflation has effectively disappeared as a real threat; the power of labour is broken, huge new competitive capacity has come on stream, particularly in China; better distribution systems, internet efficiencies, and just in time production have all allowed industry to respond more quickly. Yet still the MPC views the consequences of very mild growth as galloping inflation which has to be dealt with by checking growth. In fact the economy now needs a sustained period of substantial growth and real competitiveness to repair the damage and decline of twenty years and to enable the country to pay its way in the world long term as the oil runs down. Production, particularly the internationally traded sector, must be made profitable to channel investment in.
Current growth is not driven by production or investment but by consumer demand based on credit and rising house prices. This will be difficult to sustain long term unless growth is transferred to the productive sector but that is no reason for killing the growth itself, particularly by measures which damage production rather than consumption. If this is the view then we are back with the idiocy of the period up to floating rates when balance of payments problems were dealt with by bashing production. As they return the Bank could hardly react in the same way.
It is difficult to see the benefits of increasing inflation as a means of dealing with inflationary pressures. Petrol and oil prices have increased and may well increase again. How do higher interest rates help? How can they prevent inflationary consequences from something we can do nothing about? Isn`t the oil price hike in fact a reason to reduce interest rates rather than compound the cost increase?
Asset price inflation may be galloping. That is not the business of the Bank but of Government, particularly since the new measure of inflation excludes this consideration. In any case the increases in interest rates which have already taken place have had no effect and there is evidence that a rise to 5% or beyond will check the rise either, though of course a return to 10% plus might but only by so damaging the economy that inflation is killed by rigor mortis.
While they don`t check house price inflation interest rate hikes do inflict pain on the public. If they are already paying more for petrol, credit and mortgages they must have less to spend as consumers. So the Bank would be inflicting unnecessary misery as well as killing the one drive motor the economy has, the other being public spending, without doing anything to kick-start the production economy. That`s still in decline and still shedding jobs. An unbalanced economy may be undesirable but clobbering the consumer to bring things into balance is hardly justified when it hits the productive economy even harder.
We have as little idea as the MPC whether the house price rise will falter in the near future or go into reverse. Yet faute de mieux (and mieux is the Bank`s responsibility) it is both a major contribution to growth and precarious. It is not responsible economics to try and throw it into reverse or, we would argue, to check it just as long as government fails to tackle the issue of supply and demand. The MPC has a responsibility to analyse the effect of its measures on house price and to indicate its views of their future course.
The Bank is far too silent on two crucial areas where it owes the nation and business explanation and analysis.
The exchange rate is generally agreed to be too high, though estimates of the overvaluation vary. Ours is that it is more than 30% overvalued with inevitable consequences for investment, exports and imports. What is the Bank`s? It is also generally agreed that a lower rate is an essential spur to competitiveness, a necessary but not sufficient, requirement for growth because it boosts exports, reduces imports and makes production profitable (as it presently is not, witness the surge in outsourcing and imports).
In Germany the complaint is that the euro and interest rates are too high and that this is damaging the internationally traded sector. They recognise the importance of the exchange rate and the Bundesbank always did manage rates for competitiveness. Here, however, the internationally traded sector has been badly damaged over many years and needs to recover but the importance of competitiveness and the exchange rate are totally disregarded.
So what is the Bank`s estimate of the profitability of manufacturing, exporting, industry, production generally, opposed to the other sectors of the economy? What research has it done and what evidence is available on the effect of each interest rate increase in keeping sterling higher than it would otherwise be? The Germans want the euro lower. The Americans are looking to benign neglect. We apparently have no view. Why? What information does the MPC have on the interaction between interest and exchange rates? In our view the exchange rate is crucial. Why is it being completely disregarded by the Bank and treated as an unimportant residual?
The country is owed an explanation of the Bank`s thinking on these matters and particularly its assessments of the consequences of its own high interest rate policy on sterling. There should be an open debate on the issue. Yet all we get is an unjustified and unexplained recourse to old bankers` nostrums based on the assumption that a high exchange rate helps defeat inflation by making imports cheap, checking wage claims and forcing cost cuts. There is no logic in this strategy. Indeed its consequences can be endured only as long as North Sea oil is there to conceal the resulting impact on the balance of payments.
The Bank should explain why British interest rates and the exchange rate are being kept so far out of line with Europe, the US and Japan. It could, of course, be that we want to stimulate their economies by laying our markets open to them and limiting our exports to theirs as a gesture of European solidarity or rebooting the special relationship ie that we want to help them by harming ourselves.
If that isn`t the explanation what is it? Is our inflation rate so much higher than theirs as to justify interest rates double or treble theirs? On recent figures our inflation rate is close to Ireland`s though their interest rate has long been half ours. How does the Bank explain that? Similarly house prices inflation in the Republic, forecast to shoot up when interest rates came down because of the euro, has been much the same as ours recently, even though it is higher over ten years. Why?
If our inflation rates are very similar to those of our major competitors why are our interest rates so much higher than theirs and forecast to rise still more when their`s aren`t? Unless the Bank knows something it isn`t telling us its explanation could be that we are growing slightly faster than Europe, though not as well as the USA. This amounts to saying that growth is as dangerous to the British economy as cocaine to a heart patient.
In an interdependent globalised world the Bank owes the nation an explanation of why its policy is so much more deflationary than the monetary policy of other countries and an assessment of the consequences of this. In the past we have provided arguments to justify our advice even though arguing for interest rate reductions where the Bank regularly responds by putting them up is not a satisfactory game. We have decided, therefore, to ask questions so that the Bank can explain itself and justify its approach by reason, arguments and research rather than by reiterating bankers` saws and hunches which could have sprung from the lips of Montague Norman. Policy cannot now be formulated on the basis of instincts, hunches, assertions and mystical predictions which always put inflation at target level two years ahead but never explain how it ges there. That would make us slaves to dead bankers.
Unless, therefore, the Bank provides analysis of the effects of its policies and then attempts to justify them in terms of the real world of production, jobs, exports and imports then there can be neither rational public explanation nor discussion of the type intended when we made the Bank independent. A system in which the interests of Finance are so dominant and so arrogantly unjustified and unexplained can neither command confidence, nor be long accepted. |
