The Bank of England has spent much of the past few years proclaiming its eagerness to raise rates, just as soon as enough evidence can be assembled to justify action. The BoE has been foiled repeatedly. Reality has failed to turn out as it and others predicted.
Another episode in this saga is likely to take place on Thursday, as the BoE’s Monetary Policy Committee meets to decide whether it should increase borrowing costs from their current levels at 0.5 per cent. Financial markets think not. They have revised down their expectations of rate rises this year — though many investors are still expecting an increase later in the year.
In theory, the central bank’s deliberations may be influenced by a signal from the government that a boost to National Health Service spending suggests a more general move away from austerity. Philip Hammond, the chancellor, has a chance to lay out the administration’s fiscal philosophy in more depth at his annual Mansion House speech on Thursday. In practice, though, at least some of the health spending seems likely to be funded through taxes rather than by extra borrowing, negating its stimulative effect on demand.
The BoE should leave rates on hold. The evidence simply does not suggest that growth is strong enough to generate a sustained rise in inflation. The idea mooted by the Labour party this week that the BoE should be given a productivity as well as an inflation target may be fanciful, but the MPC must be mindful that growth has consistently disappointed and inflation persistently undershot in recent years.
The data released since the last MPC meeting in May has been mixed, and certainly does not point to a resolution of the puzzle about how much inflationary pressure the expansion is producing. Surveys show the economy expanding healthily in the second quarter, but output in the manufacturing and construction sectors has been disappointing.
Higher oil prices have driven up input costs, but there is little evidence they are feeding through into consumer prices or into earnings growth. Two of the BoE’s favoured methods of measuring wage pressure, different versions of the rise in average earnings annualised over several months, recently fell to their lowest in a year.
One of the features of the UK, and indeed of other advanced economies, is a continual surprise that rises in employment and falls in joblessness have not led to higher earnings growth. The BoE must surely conclude there may be more slack in the labour market than it imagines and the economy can be run faster without overheating.
It is in that context that the Labour party’s latest idea, while deeply unconvincing, nonetheless commands interest. It wants the BoE to add a new objective to its 2 per cent inflation target: to work with the government to increase trend productivity growth to 3 per cent.
The idea that the BoE, with its limited range of tools, could increase sustainable productivity growth to a rate not seen in modern times is simply not credible. But it is undoubtedly true that shorter-term movements in productivity, which has been strikingly low over the past decade, have some cyclical component and can be affected by central banks.
The MPC would be wise to leave rates on hold. They would be even wiser if, mindful of past disappointments, they erred on the side of encouraging a still unspectacular economic recovery rather than tightening borrowing costs on the expectation that a sustained rise in inflationary pressure is just around the corner.
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