Monetary Policy Tightening: The Straw That Broke the Camel’s Back?

Monetary policymaking is a notoriously difficult art. I say “art” rather than “science” deliberately.


It isn’t just the driving while looking in the rear-view mirror aspect of it, or Mr Greenspan’s famous observation about taking away the punch bowl just as the party starts to swing (something the Federal Reserve failed to manage in the run-up to the sub-prime crash), it’s also the need to be able to adjust to constantly moving factors.

Monetary policy has to be a dynamic art.

At the start of the year, the debate in the UK and euro zone had shifted to one of when the rate-rising process should begin.

The consensus appeared to be spring or early summer, and indeed the European Central Bank (ECB) has already signaled that rates will be going upnext month.

The Bank of England (BoE) monetary policy committee (MPC) is just edging to the point where it will raise rates (my view is not before July however). But in the last few weeks, the global economic recovery has taken a severe knock as a result of the worldwide geo-political events we discussed in our last article.

This week we had statistics showing that UK net household income had fallen for the first time since 1981. And what a grim year that was (enlivened by a royal wedding, but marred by violent street protests and rising inflation…hold on, sound familiar?), reflected in The Specials hit “Ghost Town”.

This month UK household income will be hit still further by rising tax and national insurance rates, lower tax allowances and lower child benefits. This will lead to lower demand, already reflected in the rising number of special deals and “2-for-1” offers at high-street retailers.

This fall in demand will act as a brake on inflation. Is that an argument to hold off raising interest rates? On the surface, it’s a very strong argument.

All else being equal, despite the strong influence of external factors outside the MPC’s control such as commodity and oil prices, raising rates would impact the inflation rate, as it would raise the cost of borrowing, hit household budgets and create lower demand.

So if one is concerned with inflation running away in the next 12 months, something that not an unreasonable worry, then it makes sense to start raising rates now. However, this is where a flexibility to respond to events becomes vital.

Sovereign debt worries in the euro zone are not going away, and right now a rate rise from the ECB has no beneficial impact for the southern euro zone whatsoever. Economies such as Spain, still suffering from a real-estate market crash but not yet in investors’ Greece-inspired contagion sights, will be particularly hard hit.

In the UK a successive period of falling household income has a very strong possibility of dragging the economy back into recession. So the conclusion has to be: raise rates yes, but not now.

It makes greater sense to see if the summer brings with it increased consumer demand, higher retail sales and no further bad news.

And the government’s austere fiscal policy has certainly done some of the BoE’s work for it in any case. We need to keep the interest rate powder dry for a bit longer…

Dr Moorad Choudhry is Head of Business Treasury, Global Banking & Markets, Royal Bank of Scotland, and Visiting Professor at London Metropolitan University