The level and variability of interest rates are not determined by a magic formula, but by actual and expected inflation: interest rates tend to mirror inflation performance. It has been one of the successes of UK economic policy in recent years that inflation, once endemic, has been brought under control. In fact, on the harmonised measure favoured by the European Union, UK inflation is the lowest in the EU.
However, UK interest rates are not the lowest. The lower line in the graph shows real rates -- interest rates adjusted for inflation. In the UK, this figure stands at around 3 to 3.5 per cent, rather higher than the 1-2 per cent in the euro zone. This is the price the UK has paid for higher inflation in the past, and, perhaps, for its willingness over a generation to tolerate higher inflation than its European partners. The situation may now be changing, but in the meantime we have to live with our history.
Towards the end of the Eighties economic boom, between 1988 and 1990, interest rates rose to 15 per cent, where they remained for more than a year. With hindsight, economists can argue that interest rates should not have been cut after the October 1987 stock market correction. The cuts fuelled an already hot situation and led to bust and, eventually, to recession. Rates of 15 per cent for 15 months squeezed inflation out of the system and a new period in British economic history was born.
The graph shows how much more stable interest rates have been in the years since 1993, when they have ranged between 5 per cent and 7.5 per cent, in sharp contrast to the experience of the 1980s when they doubled from 7.5 per cent to 15 per cent in a few months. Between 1993 and 1997 rate variations, under the control of the chancellor and, therefore, vulnerable to political as well as economic manipulation, were usually cuts in response to scares about the condition of the manufacturing sector, or rises to combat fears that inflation or pay was rising.
In the week following the 1997 general election, Chancellor Gordon Brown gave the Bank of England operational freedom and set up the Monetary Policy Committee (MPC). This comprises nine people -- a mixture of Bank of England economists and academic/ business economists -- and it meets monthly. Its deliberations and minutes are published two weeks after the meeting takes place (the system is highly transparent, unlike the European Central Bank). Although former chancellor Ken Clarke had his "wise men", and his relationship with Sir Edward George, now governor of the Bank of England, became known as the "Ken and Eddie show", interest rate determination remained the chancellor's responsibility.
Now the MPC has a clear brief -- to set interest rates at a level that will deliver inflation of 2.5 per cent in two years' time. It has so far been successful (or lucky).
The MPC raised and lowered interest rates aggressively in the first two and a half years of its life, changing rates almost every month, but it adopted a new stance after February 2000. It left interest rates unchanged at 6 per cent for 12 months. For rates to have peaked at just 6 per cent at the top of the business cycle is a fine achievement.
Fearing that a deterioration in global economic conditions might lead to recession in the United States, the US Federal Reserve Bank has cut interest rates by 2.75 percentage points since the new year, to 3.75 per cent, the lowest level since 1994. In response, the MPC has cut UK rates from 6 per cent to 5 per cent. The UK reduction has been much more modest than the US reduction; recession is less of a fear in the UK than in the US because of the large increases in public spending that the chancellor has announced in his last two budgets and the more robust condition of consumer spending in the UK.
Although interest rates might rise in the next 12 months, low and relatively stable inflation means that there is no risk of interest rates doubling as they did a decade ago, or even of reaching double-digit levels. This should allow businesses to plan with more confidence and certainty for the future.
David Ross is an independent economics consultant. He can be contacted on e-mail at DHR Economics, email@example.com
David Ross is an independent economics consultant who advises a range of industries. He began his career at the International Monetary Fund and has worked for John Laing and Barclays Bank.
|Printer friendly Cite/link Email Feedback|
|Publication:||Financial Management (UK)|
|Article Type:||Brief Article|
|Date:||Sep 1, 2001|
|Previous Article:||Fit for the job.|
|Next Article:||Time to operate.|