Wednesday, April 27, 2011

Inflation, base rates and the Monetary Policy Committee

I think what I'm going to say in this post is blinding obvious, and I've been surprised over recent months about the lack of any public debate over the issue. Maybe some of the economically-minded readers can explain if/how I'm wrong...

The Monetary Policy Committee of the Bank of England has one duty, which is to set the Bank of England Base Rate so as to hit the inflation target which has been set at 2% for some time now. However, inflation is currently double that figure. It is not in dispute that a higher base rate will act to bear down on inflation, and vice-versa. When the inflation rate fails to stay within 1% of the target (as is the case now) the MPC even have to write a letter to the Chancellor to explain their failure and present their strategy for fixing things. The CPI has been above this threshold (2%+1%=3%) for well over a year. The Base Rate has been at the record low of 0.5% for the past 2 years without any hint of upward movement. So why is this?

The obvious answer, that does not seem to be openly acknowledged, is that the official policy on inflation has actually been abandoned for the foreseeable future. A major cause of the current economic problem is the state of the housing market with prices still being stupidly high, but any significant drop in prices would hurt those who took out unreasonably high mortgages to pay hugely inflated prices over recent years. The (unstated) new policy seems to be to protect those who over-extended themselves, by simultaneously keeping mortgage rates at record low levels while inflating away the debts themselves. After a few years, even if house prices stay stagnant in real terms, the debts will have withered to the point at which negative equity is no longer much of a threat. For example, 5 years at 4% inflation will rescue anyone who currently finds themselves "underwater" to the tune of 25%.

The "downside", if you can call it that, is that this sleight-of-hand is being effectively paid for out of the pockets of those fools who didn't mortgage themselves to the hilt, but who actually saved their money, only to find these savings vanishing due to the same low interest rates and high inflation that is wiping out the mortgage debts. What idiots we were, not jumping in head-first onto the debt gravy train. Forget the banks, the housing market really is "too big to fail".

In most circumstances, I would expect journalists to gleefully highlight such a glaring inconsistency between stated and actual economic policy. But somehow, this de facto wealth redistribution from savers to borrowers seems to be taking place without any serious debate. Could it be that the journalists are also up to their necks in mortgage debt and delighted that the Govt is baling them out using our money?


manuel moe g said...

Low base rate is a wealth transfer from savers to the financiers - the financiers get access to capital at a very low rate from the government, and then lend it out at a higher rate. The savers get their wealth diminished by inflation. The financiers pay for better lobbyist than the savers.

In theory, a low base rate could lead to job creation by giving businesses easier access to capital to expand. Why not just offer the businesses tax breaks for job creation, and cut out the middle man? See the first paragraph.

The popular business press does not report on this because their mandate is to help close the barn door after the horses have run off.

[ Actually, the business press businessmen actually read to make decisions report on this fairly well. Among the people who count, it is not in anyone's interest to make the cynicism this plain, so it is couched is morally-neutral terminology. ]

Anonymous said...

May I suggest you are approaching this issue with a very simplistic view that you would decry in someone commenting on climate science. Increases in interest rates (the tool to combat 'inflation') will only choke off the weak recovery that is being already strangled by misguided 'austerity' measures by your government. Contractionary policy is...contractionary.

James Annan said...


If you follow the links you will see that the MPC's remit is clearly stated as being the control of inflation at close to the 2% target, and the only weapon at its disposal is interest rates. It is not my analysis but rather the entire premise of their decision-making that is simplistic.

It is hardly credible that a modest rise in interest rates would lead to either a worsening inflation problem, or a significant threat of deflation in the near future, so the weak state of the economy should simply not be a factor in their decision. At least, not according to the official policy. Inflation is way over target and has remained there right though the recent recession, and this has been directly fuelled by low interest rates.

If the Govt would come out and say that yes, they think it is a "price well worth paying" that those who borrowed beyond their means to pay over the odds should be rewarded by being basically given their expensive houses via the mechanism of high inflation AKA stealing from the savers, all for the sake of economic growth, then at least there could be an honest debate rather than the current behind-the-scenes nudge and wink about it.

Franz said...


I agree with anon, you should read some Krugman to educate yourself. A few thoughts:

If your money is short term, you have not lost anything, you can invest it (in wind energy or so), and this is the actual goal of these low interest rates. Buying out home owners is just a side effect.

If you are investet in long term bonds you have gambled just like the home owners, have been on the upside for some time (lower than expected inflation), now you are on the downside.

Inflation right now is driven by energy prices. How do you want to stop the Chines to buy oil and drive up the price? It does not make sense to increase interest rates unless wages follow these price increases.

Also you should read some Krugman about headline and core inflation.

Keeping interest rates low right now is about the only thing that makes sense in the British economy.

That debtors should be punished in an economic downturn and creditors should remain insulated is a gut reaction that is often exploited by special interests. If you saved you money you are a creditor, and you should have taken care that is invested wisely. There is no reason to complain that the central bank is pursuing a path that is not 100% for the savers.

Anonymous said...

Rather than use the simplistic term 'inflation', in the US we have a measure called "Personal Consumption Expenditures:Chain-type Price Index Less Food and Energy". Right now that level is running Year-on-year at about 0.9%. Why less food and energy? Because they are inherently volatile and, if one looked at food and energy since say 2008 they have gone through dramatic swings that have had little effect on underlying prices. Is there any wage inflation going on in the U.K. right now? I think it is safe to say the level is very low.
"The weak state of the economy should simply not be a factor in their decision." James--are you bonkers? When is the last time you read any economics? I will concede that easy credit may have led to the housing bubble(s), but that horse is out of the barn and we have been experiencing a contraction caused by a financial crisis--requiring rather different solutions than what you espouse.

crandles said...

Franz, you agree with anon appearing to side against James. But your commentary appears to me to be supporting James.

You are saying interest rates are being kept low for growth reasons while James knows this and is ahead of this in asking why this isn't being admitted.

Having said this, James' "All for the sake of economic growth" does seem to belittle the importance of that. I don't think GDP is everything but it is pretty important perhaps especially when several counties need growth to avoid being unable to pay their debts. Countries going insolvent may well take banks down with them. Would many people want to set up or expand businesses if they could get into trouble being unable to pay suppliers because their bank could become insolvent?

James Annan said...

Chris, thanks for saving me the trouble of saying it again...

GDP certainly matters, but perhaps is not of primary importance for the pensioners who make up a lot of the savers. Neither is it particularly sensible to advise them to invest in speculative investments such as wind farms. They might more rationally think of blowing their savings on a nice holiday or two and relying on the welfare state to keep them fed for the rest of their lives, rather than leaving the money in the bank where it will generate no income as it erodes away.

I don't particularly care about "punishing" debtors per se but it's surely clear that there is a huge moral hazard in baling them out with other peoples' savings!

Franz said...

Hello James,

it is basic economics that if something is in high demand, its price should increase. In a depressed economy there is increased demand in save liquid assets (money, government bonds). When interest rates are below inflation, people have a higher incentive to spend or invest their money. If you want to use these assets as storage this is the price you are paying. Nobody however is forced to waste their assets.

For example there are still liquid home owners (somebody has to hold all that debt). With rising energy prices they have an incentive to insulate their homes. That increases the value of the homes, and they receive interest due to saved energy. This is much better than idle resources. There are other investments that are relatively save and make sense.

That this policy allows home owners in debt to repair their balance sheets is just a side effect, not the main goal as you state. However it is better than forcing these homes on the market and crashing house prices.

You however make this policy a moral hazard. The savers should be provided with a perfect vehicle for storing their values without paying for it. When some prices rise beyond the control of the central bank (food, energy because of resource constraints and the Chinese entering the market), the savers should be compensated by depressing wages and retail prices. You treat this as self evident, just like Randians calling themselves 'objectivists'.

In reality you just prefer one part of society, and imply (without noting it) that all resources should be used to keep that part happy. Actually in Japan you can the effects of a policy that overly protects savers and makes investors the losers (again read Krugman about the failures of Japanese economic politics). Ironically the savers so far have been doing best in this mess, with inflation below earlier expectations and the government guaranteeing bank accounts.

I object to the emotional examples you use to avoid thinking rationally about these matters: Irresponsible home owners being baled out at the cost of savers and pensioners being lured to become welfare queens in Cameron's paradise. It is very depressing to see an intelligent person using these tactics, quite equivalent to the climate creationists. Are we doomed?

James Annan said...

Franz, putting aside all the emotive language and policy preferences, do you agree that (1) inflation is currently well above the target and has been for some time, (2) the base rate is at a historic low and has been for some time, and (3) that inflation is expected to stay well above the target for the foreseeable future?

(If you see it dropping to 2% in the next year, I'd be interested in a significant bet on the matter.)

Do you have any explanation for this state of affairs other than that the MPC has effectively abandoned the inflation target for the time being?

Franz said...

the current situation in Britain is a depressed economy, government austerity and energy price increases driven by scarcity and increased demand in China and elsewhere. As long as there is no evidence of second round price and wage increases the current policy is still consistent with an inflation target of 2%. If energy prices level off, inflation will come down.

The interesting question is, what to when energy prices continue to grow with peak oil looming. How should we absorb these shocks? I argue that even then there is no reason to introduce contractionary policies. Actually we should invest a lot then and not have people sitting around idle.

James Annan said...

"the current policy is still consistent with an inflation target of 2%"

So you may say. But the evidence points to it being more consistent with an inflation target of 4%...

I note you have chickened out of actually stating when you expect inflation to return to the supposed target value. 1 year, 2 years, 5 years???

Mighty Drunken said...

I agree with James Annan that the main reason for the historically low interest rates is not to bale out the economy as such but to prevent another run on the banks caused by a falling property market.

If boosting the economy was their main goal then increasing the base rate a few percent would do little to harm the "recovery" in my view. However due to low interest rates over the last decade many home-owners are in a bit of a pickle and barely can afford the houses they have mortgaged. The economy, after so long, has become "addicted" to a loose monetary policy.

Franz said...

I am not a soothsayer, everything depends upon what energy and food prices are doing. I expect that the central bank is going to move when core inflation, which excludes energy and food, is going to move above these 2% for some time.

The big story for the next decades is the fact that we are hitting resource constraints, however like climate one couldn't make a prediction for just one year.

And final question is, how to deal with it. Should we really reduce the value of work to almost zero just to keep the money owners happy? That is what you will have to do if energy prices really soar and the money owners still should buy the same stuff on average with their money.

This is probably my final contribution in this thread. It does not appear that I generated much interest. And frankly this scares the hell out of me.

Mighty Drunken said...

Franz sorry to feel you are not being listened to. What you have to say about energy prices and creating an environment to invest is important. This article is about interest rates and why the Bank of England has not met it's clear objective. I think that the current credit crisis (its still not fully resolved) is the main reason for this.

Of course it is unfortunate we find ourselves in this position when what we should be doing is investing in our future energy generation.

If the BoE's reason for low interest rates was investment in green energy, then it is not working!
"UK investment (in green energy) dropped by 70% from £6.9 billion in 2009 to £2 billion last year, of which 60% went to wind power."