Should interest rates go up?

Tony Dolphin challenges Oliver Kamm's argument in The Times today that the Bank of England should increase interest rates immediately.

Oliver Kamm says in today’s issue of The Times (£) that the Bank of England should increase interest rates immediately and that it should plan to have lifted them to 1.25 or 1.5 per cent by the first quarter of 2012. He suggests there is a risk of a wage-price spiral and a currency crisis if the Bank fails to act.

His worries seem at odds with the latest evidence from the economy. Average earnings increased by around 2 per cent over the last year. With unemployment just above 2.5 million, and widely expected to increase in coming months, wage deals in the private sector are unlikely to be much higher in 2011 than in 2010.

At the same time, there will be a partial pay freeze in the public sector, and tough settlements for those not affected by the freeze. The risk of a wage-price spiral seems minimal.

At the same time, sterling appears to be under little threat. Its trade-weighted exchange rate has edged up since the start of the year, is a little higher than it was a year ago and is almost 10 per cent above its level of two years ago. If the US Federal Reserve and the European Central Bank were increasing interest rates, perhaps there would be a risk to sterling’s value (though calling it a ‘crisis’ would still be too extreme).

But, they are not. Indeed, an increase in UK interest rates right now, because it would be so unexpected, would probably lead to a substantial appreciation of sterling.

What he fails to appreciate is the extent of the structural headwinds to growth over the next few years, in particular the programme of tax increases and public spending cuts, the likelihood that households will continue to reduce their debt and the pressures on banks that will limit lending. As a result of these headwinds, growth will be slow and plenty of slack will remain in the economy. In these circumstances, domestic inflation pressures are likely to remain muted.

While it is true that holding interest rates at very low levels for an extended period of time can create distortions in the economy, this risk is the lesser evil at present. An increase in interest rates now would add higher mortgage payments to the other pressures facing households in 2011: a higher rate of VAT; an increase in national insurance contributions; cuts in public spending; and wage increases running well behind price inflation.

Because these pressures will weigh on the growth of consumer spending, the economy is already likely to be heavily dependent on exports and investment spending for growth this year. Add in the effect of higher mortgage rates – and perhaps an increase in sterling’s value – and exports and investment spending may not be able to bear the strain.

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