The art of setting interest rates
The Bank of England does lots of things, but in the public eye at least, none is as important as the monthly ritual of setting interest rates. Unfortunately, its Monetary Policy Committee isn’t very good at it. In the nearest the Bank ever gets to an admission of failure, it invited Ben Bernanke, the former chief of the US Federal Reserve, to find out whether it could do better.
Last week he delivered a 75-page verdict, described by the FT as “brutally honest”. Bernanke’s version uncovered “significant shortcomings” in the way the Bank produced its forecasts. His prescription is better stats, and more attention to labour and productivity, the interaction between wages and prices (and much else).
Of course. The technocrat’s solution to almost everything is more information, quicker and wider. It would be curious were a former central banker to conclude anything else, and some of the Bank’s processes do look antediluvian by modern standards of information-gathering and analysis.
And yet…the price of money may indeed be of paramount importance in running the economy, as water is for life, but does anybody seriously think that a Bank Rate of 5 or 5.5 per cent would really make a difference from today’s 5.25 per cent?
Bank Rate really matters when it is either much too low or much too high. At the crisis level of 0.1 per cent in 2021, it was screamingly obvious to some of us that nearly-free money was an open invitation to inflation. The MPC completely failed to see this, because the tsunami had not shown up on the indicators, and a majority of its members gave the impression that they considered 0.1 per cent as some sort of new normal. The danger was not apparent in the figures, but for those of us with a long time in finance, it was all too obvious.
Co-incidentally last week saw the death of Daniel Kahneman, the Nobel prizewinner for his insight on how we take decisions. It’s clear that economics can never be a science; even if you could replicate conditions exactly, the out-turn might be quite different because people may react differently.
Kahneman’s insight was to understand how we behave when we either have to act quickly, or when we have insufficient information. The MPC can never have enough information, but every month it has to decide. The members are not encouraged to vote by gut instinct, but had more of them understood the explosive power of almost-free money earlier, we might have been spared double-digit inflation.
The members, with the notable exception of Andrew Haldane, failed to see how dangerous inflation is. They had no idea, because they had never seen it. Those of us who can remember it running at over 20 per cent know how corrosive to the structure of society it is when you can’t keep the pace with rapidly changing prices.
So seeing the folly of keeping money almost free was far more important than better models and statistics. Which brings us to today. Bank Rate may be considered high at 5.25 per cent, and we are baying for cheaper money to sustain the house price boom, but this rate, or something close to it, is probably about right. Even if the authorities manage to arm-wrestle inflation down to 2 per cent, a real interest rate of around 3 per cent is hardly usurious. It’s quite likely that the main task of the MPC in the next few years will be to resist the political pressure for more and quicker cuts. Let us hope the members have learned something from their past failure.
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