Economy Watch: Bank of England's use of interest rates can be problematic
By Paul MacFlynn, senior economist at NERI
The prospect of an imminent rise in interest rates is once again upon us. It is a spectre which hangs over businesses and consumers for months leading up to meetings of the Bank of England's Monetary Policy Committee and it provides ample opportunity for speculation from economists like me.
Interest rates are primarily used by the Bank of England to indirectly control the amount of credit in the economy - thereby controlling money in the economy and consequently the level of inflation.
To describe interest rates as a blunt instrument would not be unkind.
Adjusting central bank interest rates in order to influence prices on the high street is an inexact science and this has been further complicated in recent years.
Interest rates can also be used to boost economic activity and growth.
Increasing the amount of credit in the economy increases the amount of spending and ultimately the level of output. In response to the global financial crisis, the Bank of England slashed interest rates and this action is credited with preventing a much deeper recession in the UK.
However, using interest rates in this way is not without its problems. Decreasing interest rates can boost economic activity, but it can obviously also boost inflation.
Finding a balance between these two competing demands is the central purpose of the Monetary Policy Committee.
Interest rates have been at historic lows in the decade since the financial crisis. Post-2007 there was a fall in interest rates and an increase in inflation, but the order in which these two things occurred is very important to remember.
The Bank of England began cutting the official bank rate in December 2007, moving it from 5.75% to 5.5%. The rate was decreased five more times over the course of 2008 before finally reaching 2% that December.
Inflation also increased in 2008, but the timelines don't match.
The Consumer Price Index (CPI) was running at a rate of 2.1% in December of 2007 and increased to 5.2% in September 2008 before dropping again to 3.1% in December of that year.
In the nine months from December 2007 to September 2008, CPI inflation had more than doubled but the official bank rate had only decreased from 5.75% to 5%.
All of the subsequent interest rate reductions happened after inflation had reached its high point.
At first glance, this doesn't make sense. Why would the increase in inflation come before cuts in the interest rate?
Surely inflation should follow the rate cuts? This is because inflation is also influenced by the exchange rate.
If international investors believe that the UK economy is in a spot of bother they are likely to sell off UK assets and currency, making the pound less valuable.
This means that imports into the economy become more expensive and therefore prices increase. This is what happened in 2008.
If anything, you would have thought the Bank of England might have increased interest rates back in 2008 to curb this inflation, but they had their eyes on a different prize.
The reductions in interest rates in 2008 were designed to maintain demand in the economy; it was acknowledged then that inflation was being stoked by investor sentiment and the subsequent fall in the value of the pound.
After the initial fall in the value of the pound, inflation eased off and actually fell significantly from 2011 up to 2016.
Interest rates however remained at an historic low of 0.5% all the way up to 2016. All this time, low interest rates were aiding one of the longest economic recoveries in UK history.
It was firmly expected that as the economy fully recovered inflation would begin to rise again and interest rates would have to start increasing to keep it under control. Then Brexit happened.
Once again inflation increased from 0.5% in June 2016 to a high of 2.9% in May 2017 due to a massive drop in the value of the pound. Once again, the Bank of England sought to support the economy by dropping interest rates even further to 0.25% in August of 2016.
This all feels very familiar. Except this time certain people are clamouring for interest rates to go up again.
Indeed, the Bank of England has already reversed the decision it made to reduce rates in August 2016, believing that the economy no longer needed such support and that inflation was too high.
I think both of these judgments were wrong and the fact that a subsequent rise that had been pencilled in for May this year, did not take place in May of this year is quite telling.
The rate of inflation is falling, as it did after 2011, and the risks to the macro economy from Brexit are still large and unpredictable.
Despite this, I still think it quite likely that the Bank of England will increase interest rates at its next meeting in autumn.
The Bank of England's influential chief economist Andy Haldane has just recently lent his support to such a move.
At such a sensitive time for the UK economy it will be interesting to see if the Bank of England is willing to take such a risk.
In next week's Economy Watch, we hear from Andrew Webb of Baker Tilly Mooney Moore