The case for a constant interest rate
Will they? Won’t they? And if they do, when will they and by how much? Will it be the first of many? There are decent odds that the Bank of England is about to break the dam and be the first of the central banks within the Western industrialised establishment to cut interest rates. But then again, there are equally decent odds that they won’t. To some, setting rates – especially when it comes to cutting them – is a simple decision while, to others, it appears to be a dark art. Respectively, every argument somewhere contains a reference to inflation. But what is inflation? How much do we really know about it and what is the relationship between it and the prevailing interest rate environment?
Economics 1.0.1 tells us that inflation is created by too much money chasing not enough goods. Raise the cost of money and its velocity will be impeded. A higher cost of borrowing will not only discourage borrowing to consume, it will also decrease disposable income as a higher proportion of total income will need to be directed towards meeting interest payments on, for example, the mortgage. At its simplest, the interrelationship between goods and money, between consumer and producers, is held in the circular flow model. Once past that, econometricians have gone on to create ever more sophisticated models in order to capture the many elements that influence demand, supply, and price formation in the hope of one day finding something equivalent to the elusive unifying theory, the holy grail of physics which might one day be able to bridge the gap between Newtonian physics and quantum mechanics, both of which work on their own, but which do not work together.
The question to be asked is: to what extent does monetary policy really control inflation? That it is an imprecise science even its greatest proponents would not dispute. Not a single rate setter at the Federal Reserve, the Bank of England, the ECB, the Bank of Japan, the People’s Bank of China or any of their friends and relations would maintain that a shift in rates, be that higher or lower, will have an immediate effect on the economy. Ask them how long it takes for the change in policy rates to feed through and the reply will be fuzzy. “Some bits maybe in months, others in years.” “Can you please be more precise?” “Sorry, we really don’t know. There’s no laboratory in which this can be tested although there are computer models that give us an idea.” “And who wrote the computer programmes?” “Our people did.” “ So, they’re there to prove you right?” “Umm..”
One thing we do at least know is that central banks create money. They proved that during the past 15 years when they lent towards Quantitative Easing although much of that would be disputed by Charles Haswell, former head of public policy at HSBC, who has spent years showing his own work which suggests quite convincingly that commercial banks have a much larger part to play in the creation of money. As it conflicts with received wisdom, it struggles. Few ever argue that he is wrong although the thought of upsetting the apple cart scares many away. “We think you might be right. We’ll get back to you”. Silence.
We have gone into the current inflationary cycle with a keen eye on the great inflation of the 1970s at the same time as with fear of Fed Chairman Paul Volker’s medicine cabinet. That in 1980 alone saw rates open the year at 14.77%, fall as low as 7.65% but then close the year at 22.00%. Volker was going to wrestle inflation to the ground, whatever the cost and he is in some respects the father of hard-nosed pre-emptive rate setting. It was one of his predecessors, William McChesney Martin, Fed Chairman from 1951 to 1970, who coined the phrase that it is the Fed’s duty to take away the punchbowl before the party has started but it was Volker who took the punchbowl, then switched off the lights and threw everybody out. Received wisdom is that the period of double digit inflation in the mid and late 1970s was precipitated by the oil shock of 1973 when, in the aftermath of the Yom Kippur war, the oil producers of the Middle East turned off the taps. As an aside and maybe as a lesson to Russia, they eventually found that they were cutting off their nose to spite their own face. Let that be a subject for another day.
A longer study, however, might lead one to a different conclusion. Go back to Economics 1.0.1 and the concept of too much money chasing not enough goods. We today take the global supply chain for granted although in the 1970s the term didn’t even exist, let alone the concept. Two great and defining events in the 1960s were the Vietnam War and the NASA moon programme, both of which brought great growth to the US economy. Between 1964 and 1966 when spending was at its peak, NASA was investing around 4% to 5% of GDP in developing the Apollo programme that would in 1969 put Neil Armstrong and Buzz Aldrin on the moon. At the same time, prodigious amounts were being spent on buying hardware for the war. All of this was creating employment and pumping money into the economy while at the same time not putting goods on the shelves. Too much money chasing not enough goods, eh? The oil shock of 1973 did not create inflation – it supercharged it but it was already there and had been building for the best part of a decade. Volker is credited with having grabbed inflation by the neck and throttled it. Maybe not.
With the dialling back of the moon programme – after 1969 it largely ran on existing technology – and with engagement in Vietnam ending in 1975, there was surplus productive capacity which, as one would expect in a capitalist economy, began to refocus on satisfying the needs of consumers with money in their pockets who were hungry for things to spend it on. The economy organically began to rebalance. Did it do so because of or despite double digit interest rates? It could surely be argued that in an efficient economy demand and supply will over time always find equilibrium or perhaps more accurately try to do so. Are therefore efforts to control inflation through monetary policy in effect as futile as trying to implement a Soviet-style command economy? The jury is not out on this one because it has as yet never sat in judgement.
Is interest rate policy maybe more a popgun than a big bazooka? Is inflation not better fought by trying to boost supply rather than by constraining demand? Did Volker maybe slow the rebalancing of the economy rather than encourage it? Might lower rates not have accelerated the rebalancing?
The disinflationary period of the early years of the century and before the Global Financial Crisis was marked not by tight monetary policy but by the burgeoning supply of goods from China and other Southeast Asian economies. Lord King of Lothbury, then simply Sir Mervyn King and governor of the Bank of England coined the phrase of the NICE decade of non-inflationary constant expansion. Disinflation was not created by some clever ruse in monetary policy but by the opposite of the inflation scenario; there were too many Chinese goods chasing not enough American and European money. It’s not a quiz.
As in medicine, most cures have side effects. The side effects of aggressive anti-inflationary monetary policy are normally recession and unemployment. On that basis alone, the current US rates of 5.25% to 5.50% and those of the UK at 5.50% would have to be deemed to be anything other than aggressive. It is they, however, that are bringing inflation down or is it they that are keeping up? Would the non-inflationary balance between supply and demand not maybe come about even with a neutral setting of rates? Is the economy not self-righting, albeit over a period which might be longer or shorter?
It is often said that it was the cure that killed the patient. I shall now tread carefully as I am myself a survivor of cancer and I have within my circle of friends a number who are undergoing chemotherapy and other courses of treatment, the outcome of which remains uncertain. In the same vein, the pursuit of that elusive 2% inflation target might cost more than it is worth when it will, if it is a realistic long term inflation objective, surely find itself.
Why, if an excess of money over goods is inflationary, did QE not fuel uncontrolled inflation? Remember, in the 1970s the state was the monopoly buyer of what was produced by the defence and space industries which must be assumed to have made up the better part of 10% of GDP. At the same time, there was no globalised supply chain, so the money was to a very large extent sloshing around within the more or less closed cycle of the US economy. The post-GFC world was very different and for every dollar created, there was something on the shelf for Joe and Megan Sixpack to buy. The pandemic disrupted that virtuous cycle and….bang!
We are currently in a world focussed on – some might think obsessed with – the fight against climate change. I am not a climate denier – of course it’s getting hotter – although I do question whether all our green technology will really succeed in changing its course. That aside, the cost of developing and implementing planned technology is huge and the figures being bandied about go into the trillions. Might the drive to “carbon neutrality” not maybe be the next Vietnam or moon shot? Do Joe Biden’s trillions to be spent on carbon neutrality not risk launching the same all over again? Will they not be inflationary in the same way with money flowing into consumers’ pockets without the concomitant goods on the shelves? Global trade might initially gloss over the monopoly demand outside of the cycle of money and goods, but it is still there.
It could surely be argued that our monetary authorities are not only barking up the wrong tree, they’re possibly even doing so in the wrong forest. I could easily be on the wrong side of history but then again I might be on the right side of it when I suggest that less intervention might be better than more. When watching nature programmes with the cheetah chasing the antelope or the lion in amongst the zebras and wildebeest one is often not sure whether to root for the predator or the prey. One must die for the other to live. Its not possible for everyone to be a winner. The same laws of nature apply to the economy and to the society which it serves. Just as predators and prey find equilibrium, the same goes for the economy; they’re both defined by supply and demand. Both take time and in both cases, intervention might for a moment feel good while in the longer term, it creates further imbalances and problems on one side of the equation.
Not a popular view, especially when governments need to see results within a four or five year electoral cycle. It is said that politicians think in years but that the Catholic church thinks in centuries. Around the world, our current political set-ups can with few exceptions and with a variety of evolutionary missteps trace their roots back to the revolutionary year of 1848. The Catholic church can look back to 100 AD. Judaism of course much further. Like it or not, the latter two must have been doing something right. Along with my dear friend the Apocalypticist, the late Ed Gottesman, I have for some time pleaded for rates to be set at neutral – somewhere between three and four per cent – and left there. We would then need a lot less bankers which to many would surely in itself not be a bad thing.
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