Why the MPC will and should raise interest rates


Simon Wren-Lewis has a very nice post on why the MPC should not raise interest rates on Thursday and there is much that he says that I agree with. But the Bank has been signaling a rate rise now for sometime and if it fails to deliver on Thursday, the credibility of the MPC will be greatly diminished.

Simon argues from a conventional New-Keynesian macroeconomic framework in which labour market tightness triggers wage inflation through a Phillips curve. That, as I argued here, is a discredited framework.

Here is what I said in August of 2016 as the Fed was about to embark on a rate tightening cycle. I have substituted 'MPC' for 'Fed' in places. The reference to Friedman's optimum quantity of money can be found here and the link to Prosperity for All (now published) is here.

Conventional New-Keynesian macroeconomists assert that, to increase the inflation rate, the [MPC] must first lower the interest rate. A lower interest rate, so the argument goes, increases aggregate demand and raises wages and prices. As economic activity picks up, the [MPC] can raise the interest rate without fear of generating a recession. Some economists advocate that the Fed should raise the interest rate to meet the inflation target, a position that for reasons that escape me, has been labelled as neo-Fisherianism on the blogosphere .... My body of work, written over the past several years, (see my book Prosperity for All) explains how to raise the interest rate without simultaneously triggering a recession and, I suppose, that makes me a ‘neo-Fisherian’.

... the [MPC] should raise the interest rate on reserves and the [repo rate on overnight loans] simultaneously, thereby keeping the opportunity cost of holding money at zero and enacting Milton Friedman’s proscription for the optimal quantity of money. In addition, the [MPC] should be given the authority to buy and sell an exchange traded fund (ETF) over a broad stock portfolio with the goal of achieving an unemployment target. This is an argument I have been making for some time but it is becoming more relevant as it becomes apparent that the world does not work in the way the New-Keynesians claim.

The argument I made in August of 2016 applies equally to the MPC decision this coming Thursday. Raising the Bank Rate in an environment where the Bank pays interest on reserves is not the same as raising the Bank Rate in an environment where the interest rate on reserves is zero. The opportunity cost of credit is the difference between these two rates and, when they are equal, holding assets in the repo market is pretty much equivalent to parking reserves with the Bank. Raising both rates simultaneously will have little or no effect on the cost of credit.

If reserves and repos were the only assets; that would be the end of the story. But it doesn't end there since over half of outstanding regulated mortgages are currently on fixed rates. Banks and building societies have been lending long and borrowing short and that business will be squeezed as rates increase. There will be some impact on aggregate demand, albeit a much smaller one than if the repo rate were raised and the reserve rate left unchanged.  But the effect on demand of a rate rise can potentially be offset by use of the Bank's considerable off balance sheet asset holdings to step in and support a possible asset price crash, should it occur.

So should the MPC raise rates? I believe so.  Indeed, if the MPC wants to hit the inflation target they have to raise rates eventually. The only question is whether a rate rise on Thursday is in some sense premature. In my view it is not. The Bank has been signaling a rate rise for months and the markets expect one to occur. This is why the MPC will and should raise interest rates. Failure to act now will be damaging for future Bank communication and it will prolong the current period of stagnation.