What impact will prolonged austerity have on interest rates?


Time to shine a light on how fiscal and monetary policy interact

With prominent members of the Bank of England’s Monetary Policy Committee (MPC) – not least the Governor – lining up in recent weeks to talk up the prospect of rate rises at some point in the coming months, we can expect next week’s meeting to spark another burst of speculation about when the first hike in six years will happen.

The first small increase will be as much a psychological event as an economic one. When rates last went up in July 2007 incoming Prime Minister Gordon Brown was riding high in the polls, Obama was still the relatively unknown underdog chasing the Democrat presidential nomination and twitter hashtags hadn’t been invented. In the intervening period a very large swath of the UK’s heavily indebted borrowers have settled comfortably into the belief that rates just don’t rise. Moving from 0.5 per cent to 0.75 per cent won’t push millions of indebted households over the edge, but it will mark a turning point in our recent monetary history.

Given the scale of British household debt, and the extent to which the economy is still repairing, there is a powerful argument for moving very cautiously (an argument made powerfully by Andy Haldane).  For me, this surely means holding off while inflation is so far below target and nominal wage growth – though picking up – is still south of its pre-crisis trend. But whatever your take on the exact timings of lift-off – whether you’d opt for the first symbolic hike in August or April – we should all  agree that the far more important issue is the medium-term path of increases that follow.

The nature of that path depends on all manner of things, from what’s going on in the labour market to trends in business and consumer confidence. But it is also interwoven with George Osborne’s fiscal plan. This is, of course, a statement of the screaming obvious. It’s hardly news that what the Treasury does affects Threadneedle Street and vice versa. Which is why it is surprising that the overall mix of monetary and fiscal policy – and how the two interact – is so rarely put under the spotlight. Economic commentary tends to oscillate between focussed bouts of fiscal and monetary scrutiny. But the balance between the two? Not so much.

The Bank, of course, internally takes account of the fiscal policy being set across town at the Treasury. It uses models that include assumptions about how fiscal and monetary policies are likely to offset each other (welcome to the ‘monetary reaction function’). In seeking stable inflation and in order to underpin growth, the Bank will condition its monetary stance to take account of the nature of the Chancellor’s fiscal choices. But external scrutiny of this policy interaction – and whether the best balance has been struck – is made much more difficult by the fact that these assumptions aren’t made public. Ignorance reigns.

This is one reason why the recent speech by outgoing MPC member David Miles (to the Resolution Foundation) was an important one. It set out the extent to which fiscal policy will act as a drag on interest rates. In 2018 – by when, bear in mind, most of the work of austerity is expected to have been done – Miles calculates that fiscal consolidation will still drag interest rates downwards by more than 0.75 percent compared to what would otherwise be the case.

This is one of the factors explaining the (commonly-held) assumption that interest rates will approach a ‘new normal’ over the next few years that is likely to be about half as high as the 5% that prevailed pre-financial crisis. Even in the second half of the Parliament this ‘fiscal headwind’ will still be blowing strong.

Some caveats are needed. Miles was at pains to stress that these were only rough estimates and they were his not official ‘Bank’ figures. Nor is it clear what the basis for this calculation is: is the counterfactual no austerity at all? Would the figure change if a different mix of tax and spending was used to achieve the same consolidation? What assumption is made about sterling?  We should also note that the Miles figure differs from other calculations in the public domain. When NIESR looked at the interaction between the parties’ differing fiscal plans and interest rates it estimated that the Labour and Liberal Democrat fiscal plan would raise the base rate by 0.7 percentage points; whereas Conservative plans would raise them by 0.3 percentage points. The extra tightening associated with achieving an overall surplus (Conservative) rather than a current budget one (Labour/Lib Dems) created a 0.4 percentage point drag on interest rates.

Whatever the precise calibrations, the case for introducing more transparency is strong and is about more than mere technocratic trimming. The balance struck between monetary and fiscal policy has consequences. There are obvious distributional implications (all else equal, mortgage holders win; savers lose). There are ramifications too for the capital allocation process, the current account, and the risk of an asset-bubble. The list goes on: the macro-mix matters.

Above all better public understanding of the trade-offs between fiscal and monetary policy will help inform a key macro-policy dilemma of our times. It’s quite likely that we are now closer to the next recession than we are to the financial crisis. And as things stand we are utterly ill-prepared: rock-bottom interest rates and high levels of public debt leave us with few (conventional) policy tools. Creating more space for monetary policy to react to a future downturn is vital. Yet doing so precipitously would be hugely counterproductive, risking the very recession that we are seeking to avoid.

Monetary and fiscal policy matter greatly in their own right. Looked at in isolation we have robust institutions in place to hold policy-makers responsible for each to account – far more so than was the case prior to the Bank gaining its independence and the creation of the OBR. But scrutiny of the combined macroeconomic policy mix? In some ways it’s become more opaque since policy responsibility bifurcated.

Securing the right blend of policy over the medium term is what we should be focussed on and debating. That requires more visibility of how policy makers think monetary and fiscal policy interact. We now know a little bit more about this than we used to. But in an era defined by big economic uncertainties, which only serve to reinforce the need for policy transparency, wouldn’t it be better to bring all this out into the open?

A shorter version of this first appeared in the Guardian