Russell Lynch: Bank of England must not ‘do a Trichet’ by rushing into rate hike move

Russell Lynch: The Bank of England is naturally determined to protect its credibility on inflation
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Russell Lynch21 September 2017

The summer of 2011 was lively, and not in a good way. Riots came to British streets for the first time in a decade, but on the Continent the financial flames were raging. Fears of a Greek default spreading to Ireland, Portugal, Italy and Spain, the dreaded PIIGS, swept through debt markets. The future of the eurozone was in the balance.

This is where your central bankers need to step up and fight the fire. But not European Central Bank president Jean-Claude Trichet.

Obsessed by short-term energy price spikes, instead of dousing the flames, the Frenchman — the archetypal “inflation nutter” — flicked matches on the bonfire like a gleeful pyromaniac. He put up interest rates not once but twice.

The day of the second hike in August 2011, markets were in uproar and the Dow dropped 500 points.

There were all sorts of theories on why Trichet did what he did, like sending a political signal to the Bundesbank that he was ready to be tough on inflation.

But as an exercise in pig-headedness, it took some beating. Suffice to say his successor Mario Draghi undid the damage with two cuts in as many months by the end of the year, although it wasn’t enough to prevent the eurozone from slipping into a double-dip recession.

Now fast forward six years. Against the backdrop of a temporary inflation spike, tepid growth and the biggest structural challenge facing the UK economy in 50 years, a “majority” of the Bank’s rate-setters say they are ready to raise rates by the end of the year.

As Governor Mark Carney gloomily put it, Brexit will be inflationary thanks to shortages of workers, while “prolonged low investment” is also likely to impact our potential, again fuelling inflation risks.

Meanwhile, record low unemployment and this week’s knockout retail sales are stoking the Old Lady’s worries over diminishing “slack” and runaway consumer spending.

Carney is far from the Trichet school of inflation hawks, rather the “unreliable boyfriend” who keeps leading the market up the garden path. But that doesn’t mean he’s not capable of repeating the Frenchman’s error.

In the Canadian’s speech we got the usual shoulder-shrugging: “It is critical to recognise that Brexit represents a real shock about which monetary policy can do little.”

So why exacerbate the pain of that shock? Economics 101 says that putting up interest rates even from record low current levels will hit demand and slow the economy. And it’s ironic that nearly a year on from Chancellor Philip Hammond’s soundbite that “people did not vote for Brexit to become poorer or less secure” the monetary policy committee is about to pick the pockets of homeowners on the cusp of a period when the UK will need all the help it can get.

The OECD predicts 1% growth next year. Carney himself acknowledges we’ll be lagging the G7 economies on growth until the middle of 2018. We’re already at the bottom of the G20 growth table, barring Brazil.

The frustrating thing is that, on inflation at least, we’ll be past the peak next month: the cost of living is likely to fall back towards the Bank’s 2% inflation target next year.

So why bother hiking now? What has the MPC to lose by waiting until the turn of the year, February or even May, rather than operate in the corner it’s painted itself into for November?

The picture on Brexit might at least be clearer. Judging by this week, where we can’t even agree with ourselves, the odds of getting that EU deal look less than 50-50. And when it takes on average nearly four years to negotiate and begin a trade deal with the US alone, according to the Peterson Institute for International Economics, the Bank is likely to have to pour on the stimulus in the glorious new era.

The Bank is naturally determined to protect its credibility on inflation. But this is not the time to repeat the errors of Trichet, or even the Bank of Japan in 2001 and 2007 and the Bank of England itself in July 2007, when it overlooked the warning signs of a slowing economy and raised rates.

All of those decisions were reversed within months. An over-hasty hike could suffer the same fate.