JEREMY PEAT

It came as absolutely no surprise when the Bank of England’s Monetary Policy Committee last week announced a quarter-point increase in UK interest rates. This was fully anticipated by observers and, critically, the markets. Hence the modest rise was already factored in. This is as should be the case; expectations well managed. But that does not necessarily mean, as discussed below, that the move was optimal. The decision is still questionable.

What did come as a surprise was the way in which Mark Carney, the Bank’s Governor, was so open and so strong in predicting the substantial adverse effect that could be anticipated if there was a disorderly Brexit. These comments did have market impact and were most unwelcome so far as the increasingly challenged band of Brexiteers are concerned. Well done the Governor! Your honesty is most welcome and much to be applauded.

But let us consider first the decision per se. The vote of the committee was – unusually – unanimous. They are charged (other matters remaining constant) with adjusting monetary policy so as to keep the underlying rate of inflation, the Consumer Price Index, as close as possible to 2%. The CPI stands at 2.4%; has been, marginally, above the target level for many moons; and in the Bank’s forecast is not set to return to 2% for a couple of years.

From the MPC’s statement it is evident that they see an upside risk to inflation, despite a forecast of GDP growth of below 2%. The risk relates to their view that the supply side of our economy is growing at only 1 ½% and that ‘the UK economy currently has a very limited degree of slack’.

The UK may have moved from being the faster growing EU economy – before the Brexit vote – to about the slowest, but still we have no capacity, in the view of the MPC , to grow any faster without stimulating an unwelcome spurt in inflation.

This depressing view is founded upon the MPC’s judgement regarding the UK labour market. They see unemployment as ‘low and ... projected to fall a little further’; and anticipate, unless policy is tightened, ‘a small margin of excess demand’ to emerge next year pushing up domestic costs and hence inflation. The root cause of the inflation risk is a view that the labour market is becoming excessively tight, with an expectation of accelerating increases in real wages and hence a combination of rising inflation and reduced UK competitiveness.

This small increase in interest rates is likely to be followed, in their words, by ‘an ongoing tightening of monetary policy over the forecast period’. Hence last week’s move is not to be seen as a one-off, but rather the first of a number of hikes over perhaps the next two years. That moved up well before the Bank announces further hikes. This will cause a deceleration in already sluggish consumer demand. Such a deceleration would be enhanced in a big way if we saw a disorderly Brexit, to the possibility of which we have been further alerted by the Governor.

Please now consider why the unanimous view of the MPC is subject to question. As Professor David Bell of Stirling University has set out with great care, there is no firm base for believing that real wage growth is rising or set for acceleration. UK real wage growth in the period 2000-2008 was 15%. In the subsequent 8 year period it was zero. For several years the MPC has consistently forecast accelerating real wages; and consistently been wrong. Their response has been to re-calibrate their forecast –still to anticipate that acceleration but always in another year or two’s time.

This acceleration is anticipated because unemployment has fallen to record low levels. The Committee judges that the present rate of unemployment is broadly in line with the minimum level consistent with sustainable wage growth. They expect that growth of GDP at their forecast rate would push unemployment lower and hence cause accelerating wage inflation.

Perhaps; but David Bell and his colleague David Blanchflower (once a very forthright MPC member) believe that the MPC has ignored one critical factor. That is underemployment. The involuntary part-time employment rate rose from 2.4% in 2007 to 5% in 2012 and remained at 3.9% in 2016. There are still significant numbers in the labour force who want to work longer hours. The degree of labour market slack has therefore been under-estimated and the inflation risk over-stated.

The risk of an unnecessary tightening of monetary policy is exacerbated by the Brexit risk. As has been widely reported the Governor stressed that the risk of a no deal Brexit was ‘uncomfortably high’. He told us that the financial sector would be ready, and backed this up by reporting stress tests the Bank had undertaken which included impacts on GDP, sterling and the like which sounded horrendous! He was not of course forecasting these impacts, just saying the financial sector would be ready for the worst.

At least this hike means there would be scope to make a small cut if the worst materializes. But I would have preferred to allow the economy to progress without monetary tightening; at least until the Brexit outcome has been clarified. Given the underemployment story the inflation risk is at the margin, whereas the risk of a major hit to consumer confidence resulting in a sharp slowdown in our already underperforming economy has to be of substance. Certainly Mr Carney & co should now keep their hands off the monetary tiller until we know what happens next on the Brexit front.

Jeremy Peat is visiting professor of the University of Strathclyde International Public Policy Institute.