Super Thursday - what it means for politics
When thinking about fiscal policy, you need to think about what's happening to monetary policy too. Oh, and you need to be credible of course.
The Bank of England today once again held interest rates at 0.5 per cent. The Bank’s interest rate has not changed since March 2009. There was some expectation that the Bank might suggest a rate hike was close at hand but instead its inflation report has left some commentators with the impression that rates are unlikely to change this year. In truth no one, not even the Bank’s monetary policy committee, knows when would be the best time to raise rates. All forecasts so far have proved wrong, and there is little sign that is likely to change soon.
Today was named ‘Super Thursday’ because for the first time the Bank published its quarterly Inflation Report and monetary policy committee minutes at the same time as it announced its latest interest rate decision. The inflation report is a guide to the Bank’s thinking about the economy. In the latest report, the Bank states that the degree of slack it has perceived in the labour market is probably unchanged. While unemployment is higher than it expected, survey data from companies suggest that spare capacity in the economy has reduced. Much depends on the outlook for productivity – the bank believes productivity grew faster in the last quarter than it expected. It needs more data to determine whether the increased growth rate is durable, though it has reduced its forecast for productivity growth.
Raising productivity is the key to raising the trend growth rate of the economy. Everything else, including pledges of higher minimum or living wages, is about redistributing income and not growing it. If government does not promote investment sufficiently, productivity growth will be muted. That means that the economy will reach full capacity sooner, and so prompt the Bank to raise interest rates higher than it would otherwise have done. The inflation report contained an upgrade to forecast business investment.
It is entirely possible that the financial crisis permanently damaged the UK economy, lowering its productive potential and its long run GDP growth rate. This might explain low inflation to some degree, low interest rates, and the constant revision to forecasts. A lower trend rate of growth can still mean we have years when growth is strong, but that would be in the context of a lower average growth rate. In such a context, many of the headline grabbing pledges we are seeing in the Labour leadership election would amount to little more than wishful thinking because we would struggle to find the funds to pay for them.
The Bank faces some important risks. If it holds down rates for too long, higher inflation may become embedded in the economy and rise above the Bank’s target. If rates rise too soon, the bank risks damaging growth unnecessarily. Another risk is that the longer that interest rates remain low, the more we all get used to them being that way. Yet is it is very unusual for the Bank’s rate to remain unchanged for over six years. The risk here is that people and companies base their finances on continuing low rates, raising the probability of an adverse reaction to a rate rise.
The uncertainties are high and this is not the place for forecasts. However, it is useful to consider how politics might be affected if a rate rise is not absorbed easily in the short term. Low interest rates helped cushion the impact of the financial crisis and recession. At the same time they may have hidden the need to promote demand for goods and services and they helped government to cut spending and increase taxes, both of which hit demand. As interest rates rise, the role of fiscal policy needs to be considered. If government borrowing costs also rise, the scope to increase spending could be limited just when household finances come under further strain.
However, whatever the short-term effects, to have credible answers to the economic challenges which face us policy needs to focus on increasing long term sustainable growth in a way which benefits the maximum number of people. Labour needs to get its thinking in order here. Our economic policy should contain a combination of public investment in infrastructure and education alongside vigorous promotion of private enterprise and competition. At the same time, our policy needs to be credible on fiscal policy and controlling spending. Otherwise, both the Bank and the bond markets may conclude the risks of inflation are too high, and consequently act in a way which undermines any freedom of manoeuvre on government spending.
This article was first published by Progress on 6 August 2015.