FTA Vantage Point: Interest Rates  

Did the Bank of England raise rates too soon?

  • Explain the calculations behind interest rate movements
  • Describe why UK monetary policy may differ from the rest of the world
  • Explain how longer-term economic trends may impact the inflation rate
CPD
Approx.30min

A factor that may be contributing to inflation remaining higher is that despite economies re-opening, there has yet to be a shift in consumer spending away from goods and onto services, he adds.

During the pandemic, the closure of hospitality venues and many retail outlets led to a dramatic drop in spending on services. Some of this spending was replaced by purchases of goods. A simple example would be that people were unable to visit the gym, so they bought home exercise equipment. This led to backlogs in the production of home exercise equipment, which caused prices to rise, and so inflation. 

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Robertson says the switch back to services has yet to take place in a meaningful way, which is prolonging the production delays and so the inflation. 

He adds: “But I think the switch to services will come, and that should help inflation to ease later this year.” 

Output gap    

One of the calculations used by central banks to try to determine if interest rates need to rise is by measuring the output gap.

All economies have a trend, or long-term, rate of growth, which is the rate that can be achieved without inflation becoming too high. Deviations from this trend rate, in either direction is called the output gap,

If an economy persistently has a growth rate that is below the trend rate, then, in theory, interest rates are too high, while if it is above the trend rate, then rates are too low. 

Olga Bitel, global strategist at fund house William Blair, says: “Output gaps are very theoretical and hard to calculate. But the way we think about it right now is: imagine the pandemic had never happened and economies had continued to grow at the same rate they were in 2019, what level would the economy be at now? Well if you do that, you see that globally economies are expected to get back to that level in the US by the second quarter of 2022, and in Europe by the end of this year, or the start of next.”

Such a return would mark the closing of the output gap brought about by the pandemic. 

Bitel says if output gaps have closed and economies recovered to levels that would have happened without the pandemic, then there is no need for interest rates to be set at the level they were as a result of the pandemic. 

A second measure used by economists to understand if rates are too high or too low is r*, otherwise known as the neutral rate of interest. 

Central bankers believe they can calculate the level the base rate should be in the economy to enable full employment and inflation to be at or around 2 per cent at the same time.