JEREMY PEAT

SAD to say, but as calculated by RBS economists on the basis of UK economic history, we are probably closer to the next recession than we are to the last one!

Whilst UK economic growth is not far from the long term trend, it appears to be on a declining trend. Most forecasters expect growth of Gross Domestic Product to be lower in the second half of 2015 and into 2016 than was the case in the first 6 months of this year. But what happens thereafter?

Nobody (self included) is forecasting a recession, but there are evident perils. The main theme of this piece is that, given the domestic and international risks that we face, now is most certainly not the time to start raising interest rates from their historically low levels. That applies in the UK and the USA –two countries where hawks have started pressing for monetary tightening. In the Eurozone there can be no question of tightening until growth and inflation show signs of edging up rather than down.

As discussed in recent columns, the international risks are the continuing eurozone crisis and the sharp slowdown in China, now spreading to other emerging economies. The emerging market worries have started to feed through to the UK. Over time the effects will be slower growth, declining inflation (from a very low base) and further upward pressure on sterling (leading a further deflationary effect).

Domestically I see three key risks. First, our economic growth remains unbalanced, with lower investment and export growth than we would wish and a continuing undue reliance upon the increasingly indebted consumer. Second productivity still disappoints, as compared to both pre-recession trends and the story in other major economies – our key competitors in domestic and overseas markets. Third, inflation is exceptionally low by any standards, without any hint of an early pick up.

Let me add some flesh to the bones of this inflation story. The pressure for any interest rate hike in the USA has receded as inflation has stabilised at close to zero. The US Federal Reserve is charged with both ensuring price stability (they like the Monetary Policy Committee at the Bank of England have a target of 2% for inflation) and maximising employment. Raising rates would help to keep inflation low and stable but over time impose risks on the employment front. There is no point in exposing employment to such risks while overall inflation sticks at zero and even core inflation (stripping out more volatile items like oil and gas) remains well below target. Where is the inflation risk? There has been no change in US rates for nearly 7 years and I see no reason to expect any change for at least another 6 to 12 months.

A similar story applies in the UK. Our MPC is charged solely with the price stability target, at least until Messrs Jeremy Corbyn and John McDonnell sit in 10 & 11 Downing Street. On this basis there is again no rational reason to consider increasing UK interest rates in the foreseeable future. The UK Consumer Price index – the rate upon which the MPC target is based – has been at or close to zero throughout 2015. The highest level reached was a miserly 0.3%pa. Again it is worth considering also core inflation, with the range of indices used by the Bank averaging around 1%. All the key data point to inflation well below target. And this is before the full effects of global slowdown, declining commodity prices and the appreciation of sterling – up by a fifth over the past 2 years or so – have fed their deflationary way through the system.

The operation of monetary policy is as much an art as a science. It may take some two years for the effect of interest rate changes to feed through; certainly the impact is subject to ‘long and variable lags’ – i.e. we do not really know. But there is no evidence to suggest that an inflation problem is likely to emerge in some two years’ time, an expectation which would cause the MPC to ponder raising rates now. In my view it is simply not possible rationally to dissent from the recent judgement of Bank of England Chief Economist Andrew Haldane, namely that ‘the balance of risks to UK growth, and to UK inflation at the two-year horizon, is skewed squarely and significantly to the downside’.

The short term solution is straightforward; keep interest rates precisely where they are until any evidence emerges of a problem ahead. However, the problem which could emerge relates to deflation not inflation. As Haldane has said ‘were the downside risks [he discussed a similar set to those discussed above] to materialise there could be a need to loosen rather than tighten the monetary reins as a next step to support UK growth and return inflation to target’. We should all wish to avoid the dire peril of embedded deflation. But when interest rates are close to zero how can the ‘monetary reins’ be loosened? Are we likely to need another dose of Quantitative Easing in 2016? Both Government and Bank of England should be on the look-out for the deflation risk, and be prepared to act early rather than take any chances. Raising even expectations of a rate hike soon, with the added adverse effect this would have on the cost of servicing Government and consumer debt, would be most dangerous folly.

Jeremy Peat is visiting professor at the University of Strathclyde International Public Policy Institute