Sat, Aug 22, 2015 - Page 9 News List

Low pay, low inflation and low interest rates

The debate over an interest rate hike continues in both the UK and the US, but static pay and minimal inflation mean ultra-low rates are staying put

By Larry Elliott  /  The Guardian

Illustration: June Hsu

August 1975: Harold Wilson was the British prime minister; US president Gerald Ford had been in the White House for a year following Richard Nixon’s resignation as president; Steven Spielberg’s Jaws was the summer blockbuster as inflation in Britain hit a post-war peak of 27 percent.

Statutory incomes policy was Wilson’s response to the cost of living crisis in what now seems like a completely different world. With inflation nonexistent, today’s central banks have a big decision to make: Is it safe to go back in the water and start raising interest rates for the first time since the global financial crisis and recession of 2007 to 2009?

Some would certainly love to go for a dip. There is nothing the US Federal Reserve would like more than to be able to announce next month than the first increase in the cost of borrowing in nine years. The Bank of England feels the same way.

The reasoning is simple. The end of ultra-low interest rates would be a sign that life was back to normal. When central banks cut their policy rates virtually to zero it was as an emergency measure. Raising rates would symbolize that the emergency is now over.

The process of interest-rate normalization is taking much longer than expected. Last month, Bank of England Governor Mark Carney tested the water when he said the bank would be considering a rate rise around the turn of the year.

However, he appears to be struggling to persuade a majority of the monetary policy committee to share his view. The Fed looks closer to a rate rise, but in neither the US nor the UK is the economic data conclusive.

Indeed, the latest set of figures for the UK labor market would argue for Threadneedle Street to be cautious. Unemployment rose for the second month in a row, there was a fall in employment that would have been bigger had it not been for an increase in non-UK citizens in work, and earnings growth either stalled or fell, depending on the measure used.

When the latest set of inflation figures are released on Tuesday, they are expected to show no change in the cost of living as measured by the consumer prices index over the past year. Recent falls in oil and commodity prices, coupled with the cheapening of imports more generally due to a stronger pound, are likely to result in inflation turning negative again over the coming months.

The Fed looks closer to what Federal Reserve Bank of Atlanta president Dennis Lockhart calls “liftoff.”

However, as in the UK, inflation is well below target even when volatile items such as food and fuel are excluded from the calculation of the cost of living index.

As far as the US labor market is concerned, the good news is that the unemployment rate is below 6 percent, a level consistent in the past with the idea that rates should be heading upwards. The bad news is that the unemployment rate is distorted by people giving up looking for work, with the employment to population ratio lower than it was before the crash. Weak wage growth also suggests that demand for labor is far from buoyant.

There are arguments for higher rates. One is the risk that consumers and businesses start to assume that zero interest rates are here for good and start making reckless decisions on that basis. Those decisions lead to an overheating economy that in turn forces central banks to raise rates. Because households and firms are mentally ill-prepared, even a modest tightening of policy could have a severe impact.

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