Simon Wren-Lewis has a very nice post on why the MPC should not raise interest rates on Thursday and there is much that he says that I agree with. But the Bank has been signaling a rate rise now for sometime and if it fails to deliver on Thursday, the credibility of the MPC will ...
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Simon Wren-Lewis has a very nice post on why the MPC should not raise interest rates on Thursday and there is much that he says that I agree with. But the Bank has been signaling a rate rise now for sometime and if it fails to deliver on Thursday, the credibility of the MPC will be greatly diminished.
Simon argues from a conventional New-Keynesian macroeconomic framework in which labour market tightness triggers wage inflation through a Phillips curve. That, as I argued here, is a discredited framework.
Here is what I said in August of 2016 as the Fed was about to embark on a rate tightening cycle. I have substituted 'MPC' for 'Fed' in places. The reference to Friedman's optimum quantity of money can be found here and the link to Prosperity for All (now published) is here.
The argument I made in August of 2016 applies equally to the MPC decision this coming Thursday. Raising the Bank Rate in an environment where the Bank pays interest on reserves is not the same as raising the Bank Rate in an environment where the interest rate on reserves is zero. The opportunity cost of credit is the difference between these two rates and, when they are equal, holding assets in the repo market is pretty much equivalent to parking reserves with the Bank. Raising both rates simultaneously will have little or no effect on the cost of credit.
If reserves and repos were the only assets; that would be the end of the story. But it doesn't end there since over half of outstanding regulated mortgages are currently on fixed rates. Banks and building societies have been lending long and borrowing short and that business will be squeezed as rates increase. There will be some impact on aggregate demand, albeit a much smaller one than if the repo rate were raised and the reserve rate left unchanged. But the effect on demand of a rate rise can potentially be offset by use of the Bank's considerable off balance sheet asset holdings to step in and support a possible asset price crash, should it occur.
So should the MPC raise rates? I believe so. Indeed, if the MPC wants to hit the inflation target they have to raise rates eventually. The only question is whether a rate rise on Thursday is in some sense premature. In my view it is not. The Bank has been signaling a rate rise for months and the markets expect one to occur. This is why the MPC will and should raise interest rates. Failure to act now will be damaging for future Bank communication and it will prolong the current period of stagnation.