The US central bank is cutting interest rates with speed, vigour and decisiveness. The decision by A...
The US central bank is cutting interest rates with speed, vigour and decisiveness. The decision by Alan Greenspan and his colleagues to cut US rates earlier this month means they have fallen by 1.5% so far this year. He has also made it clear that he is prepared to reduce rates further if the US economy continues to weaken. I expect him to cut rates by another half percentage point at the next meeting of the Federal Open Markets Committee (FOMC) on 15 May. He may even make an inter-meeting cut.
Meanwhile, Alan's counterpart, Eddie (now Sir Edward) George and his Bank of England Monetary Policy Committee (MPC) have been much more cautious. They have only cut rates by a miserly quarter per cent and do not seem inclined to move much faster. Of course, growth is slowing much more rapidly in the US. But the UK MPC put rates up just as quickly as the FOMC even though growth here was nowhere near the boom seen in US.
The result is that the gap between UK and US short-term interest rates official interest rates here are now three-quarters of a per cent higher here than in the US is likely to widen further.
So why is the UK MPC so reluctant to match the boldness of the FOMC? One important reason is age. The Bank of England may be 300 years old but it was only given operational independence in May 1997. The Federal Reserve has been more or less independent since it was founded in 1913. Establishing credibility is important for any new institution, and for a central bank it is vital. If the central bank can convince the general public that it will keep inflation low and stable, the economy will run more smoothly and efficiently.
For example, suppose that the current foot and mouth scare leads to a rise in meat prices sufficient to push the overall rate of inflation up. If workers and their bosses think that this might lead to a mini inflation spiral, they might just agree on higher wages. This of course will guarantee that there is a spiral. Interest rates would then have to rise to squeeze demand and stop the spiral. If by contrast everyone is confident that the inflation increase is a blip, they will ignore it and it will indeed be a blip.
In the early days of the Bank of England MPC, it was important for them act very cautiously in order to build up credibility. Given the UK's chequered history when it comes to inflation fighting that meant erring on the side of toughness. If in doubt, put interest rates up.
But the world has moved on and the MPC has been keeping monetary policy too tight (which means that they have kept interest rates too high) for at least a year. Of course, they argue that they set rates to hit the Government's 2.5% inflation target and that they are as worried about under-shooting as they are about over-shooting. But look at chart 1. Yes, they have kept inflation well within the target tolerance range but inflation is on a downward trend and could well fall below the 1.5% lower bound over the next few months. Moreover, it is now widely recognised that the RPI is a biased measure of inflation that overstates the true rate of price increase by at least half a percentage point. On the harmonised European measure, the UK has the lowest rate of inflation in the EU. We now face a global slowdown and despite record-low unemployment, wage inflation is trickling down. The MPC is in danger of losing credibility for being too tough.
When Sir Edward and his colleagues face this sort of criticism, they reply by saying they set rates with respect to prospective inflation not current inflation. That is the only way to act: there are long time lags between interest rate changes and the impact on inflation. This means that they have to set rates on the basis of a forecast over a two-year time horizon. The problem is that these forecasts have been systematically pessimistic. The MPC keeps expecting inflation to rise and therefore keeps interest rates too high.
Why do they do this? I think I can understand their psychology. I started my career in the Treasury in the mid-1970s and worked on monetary policy jointly with the Bank of England under both Labour and Conservative Governments. Three of the current MPC members were then colleagues.
Time and time again we seemed to have endured sacrifices to reduce inflation only to lose our nerve and throw it all away. The UK seemed to have a built-in sensitivity to inflation. So when the MPC was set up, I supported their tough approach: this was an opportunity to reduce inflation without being thrown off course by political storms.
But since I transferred to Deutsche Asset Management in 1999 and started seeing UK companies as an investor, I have realised that the world has changed. In the 1970s and 1980s, unions negotiated whatever wages they could get away with and companies knew that they could pass the costs onto a compliant consumer. Indeed, large swathes of the economy were in the hands of nationalised industries where profit was a secondary concern. Today is a very different world. Companies find the prices they can charge being dictated to them by the marketplace and this tells them how much they can afford to pay their staff. Tough regulators are forcing the former nationalised industries to cut prices year after year.
Far from putting prices up, the challenge facing many companies is how to stop prices falling. When I met with the chief executive of one of the country's largest retailers a year ago, he asked me when I thought the recession would be over. I did not know what to say because the recession in the overall economy had been over for seven years. But he wanted to know when retailers would be able to regain pricing power. And the answer is perhaps never.
Competition remains intense. I fear that my former colleagues just don't appreciate how much the UK economy has changed. Indeed, it is interesting that the two members of the MPC who have consistently argued that interest rates are too high, DeAnne Julius and Sushil Wadhwani, are not part of the mainstream monetary economics tradition. They are the only members of the committee who can reasonably claim to have direct experience of the private sector.
My argument is not just that I have a better forecast of inflation. I have made too many forecasting errors of my own to be that arrogant. But the weight of the financial markets is on my side. The chart opposite compares the UK and US yield curves. We often talk of central banks 'setting interest rates' but in fact they only set very short-term interest rates. Rates for longer maturities are determined freely by the marketplace. The chart shows that UK rates are much higher than their US equivalents at the short end. But longer, free market rates are actually lower in the UK than in the US. Of course, these rates are heavily influenced by what the market expects the central banks to do in the future.
On this interpretation, the Fed is expected to cut so aggressively this year that the US economy rebounds in 2002 at which point the Fed can begin raising rates again. In the UK, by contrast, the MPC drags its feet, squeezing inflation still lower and keeping growth sluggish. I think the MPC should take a leaf out the FOMC's book and boldly cut UK interest rates by 1% immediately. That's what I think they should do. What they will do is very different: a quarter per cent here, on hold there, and rates fall so slowly.
Steven Bell is chief economist at Deutsche Asset Management
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