Mark Carney's Right; Now Is Not The Time To Lower Interest Rates

The Governor of the Bank of England, Mark Carney, is quite right here when he says that now is not the time to lower interest rates. It’s entirely true that inflation is below the 2% target that the Bank has been set but that’s still not a reasonable reason to lower interest rates. For it depends upon what it is that is lowering inflation. If it’s a supply shock then that’s something to worry about a great deal less than if it’s a demand shock. And if it’s a temporary supply shock then it’s almost certainly something best ignored when considering interest rates. For, as Carney points out, monetary policy takes time to have an effect on the real economy. And we expect this supply shock to have worked through the inflation figures by the time any interest rate change would have an effect. Thus, now is not the time to change interest rates:Bank of England governor Mark Carney yesterday implied that talks of a cut in interest rates nearer to zero were overblown.

 

In more detail:

Bank of England policymakers would be “extremely foolish” if they took the “unnecessary” step of trying to fight the current period of low inflation by pumping more stimulus into the economy, Bank Governor Mark Carney has said.

Mr Carney said the Monetary Policy Committee (MPC) that sets interest rates was “looking through” the current period of low inflation because it was driven by a 50pc fall in oil prices since last June.
He said the fall, which had filtered through to cheaper petrol costs and lower food prices, would account for four-fifths of the gap between actual inflation and the Bank’s 2pc target by the Spring.

This is exactly correct.
We most certainly don’t want a general deflation. Where as everyone feels that they have less money in their pockets they spend less and this leads to generally falling prices across the economy. We would describe this as a demand shock and we’d very definitely do something with interest rates (or unconventional monetary policy if necessary to counteract it).

However, where low inflation is a result of a supply shock, like the global fall in oil prices, we’re a great deal more relaxed about it. Firstly, this fall in the oil price does not mean that people have less in their pockets. Quite to the contrary, it means that they have more available to spend on other things. Secondly, we know that this is only a temporary reduction in inflation. No, not that the oil price decline is only temporary (who knows?) but that the effect on the decline on the inflation figures is only temporary. If oil prices halve in a year then they will only affect the inflation figures for the subsequent year. After that the effect of the lower price is out of such figures. It’s only if the oil price keeps halving every year that it will continue to show up as low inflation: and no one, at least pretty much no one, thinks that that is going to happen.

Carney also makes the point that monetary policy takes time to work through the economy. The normal rule of thumb is 18-24 months. Meaning that if we did cut interest rates now then by the time they had any effect then the oil price fall would already be out of the inflation figures. So, best not to do it then.

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