There are some institutions in which the public seems to place extraordinary trust, just because they are institutions (there are some people that seem to have this status as well). In the field of finance, the central banks are just such institutions. It was, of course, a series of catastrophic policy and regulatory errors made by some of the world’s major central banks in the years running up to the financial crisis that were a primary cause of the implosion that is still reverberating around the world economy. Regardless of this, there remains a blind but wholly misplaced faith that most central banks are now getting it right.
So, it is with a necessary degree of scepticism that we should look at the US Federal Reserve’s current policy course and ask whether the financial markets are right to be nervous. Is the continuing process of raising interest rates correct or is the Fed taking an inappropriate and unnecessary risk?
I happen to think that on this occasion, the Fed has got it about right. While it has actually tightened far less quickly that it warned it would, the aim of getting interest rates back to more normal levels has to be economically sensible.
There is a lot of straight-line thinking amongst economists and financial commentators. In relation to monetary policy, this type of thinking dictates that low/lower interest rates always act as a stimulus to nominal growth, and that high or rising interest rates detract from growth. However, whereas this might normally be true, at extreme levels of interest rates, there may be perverse effects.
I think that ultra-low interest rates may actually dampen growth, because they reduce challenge in the system. In real terms (i.e. after adjusting for inflation), risk free rates, measured either by short-term interest rates or by government bond yields, have been near-zero or negative for an extended period. Although this may encourage some entrepreneurial activity by allowing start-up and very small businesses to borrow at better than normal rates, the bigger impact on the economy is to discourage productivity-enhancing investment spending. This is because larger companies can easily beat the returns offered by less risky financial assets through their normal dividend payments and base profits growth, without embarking on risky investment projects. Were interest rates higher, companies would have to work harder to make returns that provided sufficient risk-adjusted rewards to investors. I would also dispute that low interest rates are significantly helpful to smaller companies – the much bigger issue for most is access to credit and investment, not the price thereof.
In effect, abnormally-low interest rates encourage economic laziness.
The Bank of England has fallen into the low-interest trap, and continues blindly and unquestioningly to dig itself deeper. I find it staggering that the Bank’s Monetary Policy Committee has not confronted a very obvious conundrum. Why is it that the economy continues to post such sluggish growth rates despite having been the beneficiary of unprecedented monetary accommodation – made up of massive quantitative easing and exceptionally low interest rates?
In my view, the Bank can reach only one of two conclusions. Either the economy has performed poorly despite the policy course the MPC has followed or because of the course it has followed. Both conclusions are indicative of policy failure, but the latter would also show a hapless inability to understand the growth dynamics of the economy. This, I believe, is the truth of the current situation.
Despite the transparency that surrounds the policy process in the UK, there is no true accountability. If the Bank were held properly to account, and if we were willing to show a lesser degree of blind faith in its capabilities and reverence for its status (the latter seemingly preventing any constructive analysis by or criticism from most City economists and analysts), it might lead to a better quality of economic debate and more inciteful and effective policy decisions.
Unfortunately, the Bank currently has yet another excuse for its long-term policy inadequacies – Brexit.
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