Britain Long Read

The UK economy is overheating. Carney to the rescue

In November of last year, the Bank of England raised the base rate for the first time in 10 years. Further rate rises are likely soon

Monetary policy is defined as a process of setting interest rates to reach specific inflation targets. A tightening of monetary policy is where the central bank raises the interest rate to discourage borrowing in order to lower inflation. In November, the Bank of England (BOE) had raised the base rate from 0.25% to 0.5% and is likely to continue increasing it for the next three years. Is contractionary monetary policy wise in current economic climate?

The global economy is progressing with strong momentum, and Britain has one of the lowest unemployment rates in recent times. The economy is nearly at a point of overheating. There is low spare capacity and inflation is around 3%. So yes, to cool down the economy tightening of monetary policy will be very useful.

Chart 1.1 shows global growth since the start of 2016. Both the eurozone and the US are growing quickly for the first time since the financial crisis. The Financial Times said that ”the economic confidence across the eurozone has hit its strongest level in more than 17 years,” meaning that both firms and consumers are more confident to spend. In theory, this should boost demand for UK exports. The BOE has stated that in 2017 output growth has increased to 0.5%, mainly been due to the manufacturing sector. However offsetting this increase, output growth in the services industry has weakened along with the oil industry taking a hit due to the closure of a major pipeline. Construction activity has also slowed down, leading forecasters to believe that in the first quarter of 2018, output growth will slow down to 0.4%.

Even though strong global growth has caused the UK to experience a spike in output, internal factors (e.g. closure of the pipeline) may cause the output to dampen. If the service sector continues declining, it would not be advisable to continue the contractionary monetary policy, as this will further decrease real national output. However, forecasters believe that the slowdown in output is only temporary. In fact, the oil pipeline has just been reopened and will soon be producing at maximum capacity. Mr Carney should still adopt the tightening of the monetary policy to ensure growth is not too high in the coming quarters. Monetary policy has to be pre-emptive.

Currently, inflation in the UK is 3%, exceeding Mr Carney’s 2% target. The reason for this is the depreciation of the pound, following the Brexit referendum. It is now more costly for businesses to import raw materials, increasing their cost of production. As a result, firms pass on rising costs to consumers in the form of higher prices. To counteract this, a tightening of the monetary policy should be used to decrease aggregate demand and consequently reduce inflation.

Although growth in the UK economy is expected to grow, there is a limit to which it can actually grow. The potential growth rate of an economy is the rate at which an economy can grow without inflationary pressures. It is determined by the economy’s supply capacity, which is the difference between demand and potential supply. The BOE estimates the degree of capacity to be 0.25% of GDP. Since very little slack is judged to remain in the economy, the speed at which output can expand without generating inflationary pressures will largely depend on growth in potential supply. That growth can be driven either by increases in labour supply or productivity. Net migration has fallen to 230,000 from 336,000 in the previous year. The ONS projects a further fall in annual net migration, to 211,000 by mid-2020. Potential labour supply is projected to grow by 0.4% per year on average over the next three years, which is much lower than changes in previous years. Hence, potential labour supply growth is expected to be subdued relative to the past decade. The potential growth rate is not expected to rise as structural productivity growth is not expected to increase either. So, the level at which output can grow without leading to inflationary prices is modest.

Evidently, domestic inflationary pressures are rising. Mark Carney was right to start tightening monetary policy in November, and he should tighten it further in 2018 to ensure price stability for the future of the UK economy.

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