The Bank of England faces a dilemma over interest rates.
The Bank of England slashed interest rates to a 300-year low in March 2009. Inflation in the UK now runs at more than twice the level targeted by the Bank, and private sector wage settlements are 50% higher than the target level of inflation, despite high unemployment.
Yet the Bank remains reluctant to increase interest rates. Something has changed in Threadneedle Street, with far-reaching consequences.
The Bank's mandate
It is worth reminding oneself of the terms of the Bank's mandate, set out in the Bank of England Act 1998. This requires the Bank to maintain price stability, currently defined as an inflation rate of 2%, as its sole overriding objective. By law, the Bank must deliver 2% even if this undermines or contradicts the UK Government's economic policy.
This was the revolution instituted by Gordon Brown: interest rates could no longer be manipulated for political ends; instead, they were transferred to an independent body of experts whose primary and overriding legal duty was to keep inflation to a predetermined level at all times.
Banning inflation by law
This structure went on to save the UK billions of pounds by reducing the interest rates it had to pay on its debts. Since most government borrowing is carried out at fixed interest rates with an average loan period of 14 years, any hint of a risk of inflation would result in lenders demanding far higher rates of interest.
The only way of convincing lenders that inflation was a thing of the past was to make inflation illegal, which is effectively what the Bank of England Act 1998 tried to achieve.
It is no surprise then that Gordon Brown went on to sell half of the UK's gold supply a few months later. Since gold loses its value when currencies are stable and inflation is a thing of the past, he thought he was selling at the top of the market.
The Ghost of Depression Past
We now know that inflation was not to be banished so easily. Why? Partly it was down to the fear in 2008 that the West was headed for another Great Depression.
The last Great Depression is widely perceived to have been caused by the Federal Reserve tightening interest rates too quickly. No central banker wanted to make that mistake again, so when the financial system appeared on the verge of collapse in 2008 interest rates were slashed to historic lows and money was printed, while at the same time national governments throughout the world engaged in massive stimulus spending. The fear at the time was of Depression-era levels of deflation, so inflationary steps were welcomed.
The curse of Brown
Unfortunately, national governments have now run out of money and are desperately reversing the unprecedented stimulus spending of the last three years. This, then, is the nightmare on Threadneedle Street -- with the Government slashing rather than increasing spending, the Bank of England is simply the last institution standing, the only entity which can keep the UK out of recession, unemployment low, consumer confidence and asset prices high and UK banks out of meltdown.
The power transferred to the Bank of England Act in 1998 has turned into a curse -- as the only institution with any remaining power to stave off a recession, the Bank now has to do whatever it can do achieve this, even if this is contrary to its legal mandate. So interest rates were slashed, the pound fell by over 20%, import prices rose and inflation rose; but the alternative was unthinkable, and probably still is.
Sowing the seeds of the next crisis
If the law of low inflation at all costs is effectively suspended for the duration of the crisis then we can expect inflation to remain higher, and interest rates lower, than might otherwise be expected. But the law of unintended consequences will have its part to play, so we must also consider whether this combination of abnormally low rates and high inflation contains the seeds of another crisis.
The current crisis was caused by too much debt, but low rates encourage more debt, not less. Low rates also force capital to find riskier assets, from which it will no doubt flee as soon as rates increase.
Fear of a wave of foreclosures and a property collapse (followed by a renewed banking crisis) are one of the reasons why the Bank of England has been reluctant to raise interest rates since the crisis took hold. But the Daily Telegraph estimates that since the crisis started in 2007 about 250,000 households in the UK have transferred their mortgages from a repayment mortgage to an interest-only mortgage, vastly increasing their vulnerability to interest rate rises.
Thus the consequences of a rise in interest rates become worse every day, further delaying the first rise while at the same time increasing the damage that higher interest rates will eventually wreak on the UK economy. Fools might want to consider preparing for a second chapter to the financial crisis once interest rates start to tighten.
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