Interest rates will have to rise but real focus must be on jobs and growth

Inflation is back. The recent rise in the UK’s headline rate above the Bank of England’s 2.0 per cent target for the first time in two years came just a few days after the cost of living in the United States hit a 13-year high.

Money market traders have for some time been raising the interest rates that banks and lenders pay – and which get passed on to us via mortgages and car loans – while City analysts have started debating whether the Monetary Policy Committee (MPC) should raise its borrowing rate as early as next year.

Two outcomes are all but certain when the Bank of England’s MPC meets this week. It will decide to leave policy unchanged with just one member – outgoing chief economist and innovative thinker Andrew Haldane – voting to tighten the taps by pulling the plug on its £875bn quantitative easing programme.

Rising inflation should be no surprise: vaccinations have triggered a rise in activity that will, in turn, lead to more consumer spending and business investment. Interest rates will at some point have to rise for the first time since August 2018 and the QE programme will be gradually withdrawn.

But this cannot mark a return to the sterile monthly debate seen in the Noughties: whether rates would rise by a quarter of a percentage point or not. So much has changed since then that to treat a hike in rates as a harbinger of a new Roaring Twenties revival would be folly.

While it is tempting to see low inflation and interest rates as a symptom of Covid-19 and expect they will rise as rates of new cases, hospitalisations and deaths fall, that would miss the massive structural changes that have taken place.

Interest rates have been close to zero since March 2009 when the Bank intervened to avert a depression in the wake of the global financial crisis (GFC).

Unlike the pattern seen regularly over the previous two centuries, economic activity did not snap back like a coiled spring, but instead crawled along at a lacklustre pace.

Unemployment may not have hit the 3 million level seen during the 1980s recession but wage growth has slumped. The furlough scheme has kept 2.4 million in income but with little confidence their jobs will be there once the safety net is removed.

Remember also that QE has benefited those with wealth as a result of its impact on the prices of assets such as property, shares, bonds, art and even cryptocurrencies.

The onus must be on policymakers to rebuild an economy that works for people rather than the other way round. As the Resolution Foundation think tank has pointed out, they should worry far more about rising unemployment than rising inflation.

Some of the causes of our sluggish economy were baked into the cake even before the GFC. One is the ageing demographic – rising life expectancy, lower fertility rates and higher dependency ratios that reduce long-term growth. Another is the so-called long-term savings glut by China and other Asian countries that have kept money market rates low.

But the one issue policymakers must address is the collapse in productivity growth. It might sound dull, but productivity is the kernel of economic health. As Nobel Laureate economist Paul Krugman said: “Productivity isn’t everything, but, in the long run, it is almost everything.” The reason is simply that a country’s ability to raise its standard of living depends almost entirely on increasing its output per worker.

UK productivity levels have been dismal by international standards and have stagnated in recent years compared with a historical long-term growth rate of 2.0 per cent a year. The Office for National Statistics has calculated that if the trend seen up to 2007 had continued, productivity would now be 16 per cent higher than it actually is. Today’s economy would have been some £300bn larger, equalling an average of £11,500 per household.

There are many contenders for the cause. It could be technology eliminating well-paid jobs and forcing people into lower-paid work. Or the reluctance of employers to shed workers in the wake of the GFC, leading to falls in productivity as output slowed. Perhaps it is the low level of investment post-GFC, or banks’ reluctance to lend to new businesses.

Thankfully, the Economic and Social Research Council has funded the creation of the Productivity Institute to investigate this puzzle. Solving it is essential – even more so now that coronavirus has impacted severely on growth. Failure to do so will leave future generations in a low-wage trap as prices and rates rise.