Thursday, July 10, 2008

The Bank of England & Interest Rates

I just thought that I should make a quick post regarding interest rates. Has the Bank of England taken the right action over interest rates? Many of the points here also apply to the US economy in principle, though the fed approach appears to be more realistic.

The short answer is 'no'.

Why on earth is the BoE worried about inflation? The reason for worry over inflation should be a concern as to whether the economy is reaching or exceeding capacity, or if the money supply expands too quickly. The really tragic part is that, had the BoE joined the real world some time ago, they would have noted that real inflation had been sky-rocketing for many years. For reasons which will always baffle me, the largest part of the expenditure of most individuals is excluded - housing costs. Furthermore, the bank failed to note the massive expansion in the money supply in the UK economy and carried on as if nothing was happening.

Why was previously inflation (apparently) so low? About three years ago, in an economics lecture, I was pointing out that the entry of the BRIC countries into the world economy was the only reason for inflation being held down. It was nothing to do with the BoE or any clever management of the economy. In such benign conditions - of course the price of consumer goods was held down! That did not mean that the underlying economy was not massively overheating.

Furthermore, the entry of the BRIC countries into world trade not only pulled down the price of products, but had also placed a lid on wage increases due to the competitive threat that they presented (as well as the low inflation they created). I have noted that, in the last year, the economists have finally grasped this. However, what they have not grasped is that inflation has long been out of control in the UK - it just didn't look that way because they were looking in the wrong places.

We now have a situation where the UK economy is about to massively deflate. If we consider house prices, then deflation is already raging. As the economy sinks into depression, spare capacity will inevitably appear in the economy. It is exactly at this time that the BoE should actually be starting to relax interest rates. Whilst oil prices are feeding through into current inflation measures, the BoE needs to recognise that, as the world also goes into recession, oil prices will fall back as world growth goes into reverse. Also, the oil price is an external factor that is not a capacity bottleneck in the UK economy, but an external inflationary shock that is outside of the control of UK interest rates.

Another area for concern is food prices, and they will remain a problem. The lunacy of biofuel production is one of the root causes of this problem, but also demand has increased with the growing wealth of the BRIC countries. As such, there will likely be a time lag before food prices stabilise, partly as a result of the time it takes to expand capacity, and in part dependent on how long the silliness of Biofuels will continue. However, in the overall picture of deflation, food price inflation is a fairly minor matter in comparison with housing, oil, and the downward wage pressure that will come with recession.

Whilst everyone is focusing on oil and food, we need to consider another factor in inflation, and that is the value of the £GB (and the same goes for the $US for the US). It is inevitable that these currencies are going to continue to be weak, probably with further declines, which will make imports more expensive. This kind of inflation is actually a good thing, as the fall in the currency is part of the process of rebalancing in the world economy. The simple truth is that the Western economies are simply not as wealthy as they believed, and therefore the currency declines are just an expression of that reality. Whilst this will feed through into price inflation for some goods, I do not believe that it will have the impact that it might have had previously, as the retail sector is going to have a sharp decline/crash, making discounting ever more necessary to gain customers. Whilst such harsh conditions will not remove the effects of a weak currency, they will ameliorate them.

Furthermore, with unemployment rising, this inflation in the price of imported goods will not feed through to wages. When people fear for their jobs, wages will not rise (although there may be a slight blip up in the coming 3-4 months whilst everyone adjusts to the reality of the situation). The one potential area for wage inflation is the state sector. However, with recession/depression lowering tax revenues for the government and expenditure on unemployment rapidly rising, where will the government get the finance to pay for higher wages? The government will have enough trouble paying for the wages as they stand and will almost certainly need to implement cuts in state sector employment.

In summary the BoE is making yet another error. The fight against inflation under the current circumstances is, quite simply bizarre - but then again the economic policy of the last ten years has been equally bizarre. Despite this, I still find it astounding that the BoE treat the current circumstances as anything but a spur to lower interest rates. Underlying this BoE stance appears to be macho posturing, a response to metaphors about 'fighting inflation' or 'containing inflation'. It seems that everyone has forgotten what interest rates are used for in the context of inflation. Interest rates are used to rein back capacity and money supply in the economy when it is overheating.

The economy is collapsing, not overheating. The money supply is going through what may be unprecedented contraction. As I have said - an astounding decision!

Note: Another point I can not help making (even if a little off the topic) is to ask; why have government borrowing in the first place? There really is no excuse for it, except in national emergency. Government borrowing is at the root of the whole idea of central banks, or government, setting interest rates. In a rational world, they would have no part in the system of how interest is calculated.

So, why do governments borrow?

I will leave this point here, but hope that you will contemplate this question for yourself at your leisure.

1 comment:

  1. Re. the question at the end of the article.

    I know it wasn't your intention to write an Elementary Economics course but, for ignoramuses like me, could you quickly explain how a central bank's interest rates are related to government borrowing?

    I had assumed that the central bank set domestic interest rates to create a feedback loop to keep the amount of money in its own economy at the 'correct' level i.e. to regulate inflation. I didn't think the rest of the world cared, as whatever happened, the exchange rate for the currency would reflect its true value.

    I am a bit hazy on government borrowing. I assumed that a government could borrow 'money' on the financial markets at the cost of paying it back with interest (at a rate set by... some international committee or other) - like a business borrowing money within a country's economy. I have no idea in what currency this loan would be made (as I say I am very ignorant!)

    The borrowed money would be used to boost short term cashflow, with the assumption being that it could be repaid in future due to improved economic circumstances, or when 'investments' reduced costs in the future. (And as a bribe to the electorate, no doubt.)


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