This is nuts, inflation does not justify zero interest rates

Inflation is down to 1.6pc, below the Bank of England's 2pc target. No chance of an interest rate hike soon then? I think that argument is wrong. The UK needs tighter monetary policy.

Keeping interest rates at record lows is unnecessary and unsustainable given rapidly falling unemployment and signs of a booming economy. Indeed, the argument that a small inflation undershoot justifies the loosest money policy for 300 years shows just how skewed perspectives have become.

Let us recap. The Bank of England cut interest rates to a record low and launched massive bond buying in the aftermath of Lehman Brothers collapse. It took that nuclear option to combat the risk of the economy shrivelling without a trace.

In my view, that was the right decision. Had the central bank not taken those steps, the result would have made the disaster of the past few years look like a children's picnic.

By swapping cash for government bonds, Bank of England quantitative easing drove down long-term interest rates. Probably the most important impact of the policy was on confidence. The central bank showed it still had ammunition left.

Those policies were a response to an imminent disaster. The equivalent of convening the COBRA emergency committee. You do that for wide scale flooding, not for a spring shower.

There is no imminent disaster now. The UK has not done well, to put it mildly, over the past few years. But the outlook for growth is strong. Employment is surging, up 240,000 in the three months to February, and business surveys point to boom times ahead. The most likely outcome over the next few years is solid, possibly above trend growth. That is my own forecast. But also the IMFs for 2014, and a host of other forecasters.

Inflation is modestly below the central bank's target. That would justify modestly below normal interest rates, say a half point. For instance, inflation was touching 1pc at times in 2004, but interest rates were not cut to zero. Why? Modestly below target inflation does not require emergency monetary stimulus, especially when the economy is growing strongly.

Something called the “Taylor Rule” is a good way to judge appropriate interest rates. Take average interest rates over the past and subtract one and a half of any inflation undershoot and half of any output gap. It is simple, but it is not half bad at describing sensible central bank behaviour.

Assuming an output gap of 1pc-1.5pc, as the Bank of England does, that means interest rates are between one and one and a half percent below normal right now. Modestly below target inflation does not justify record low interest rates.

Moreover, it is where inflation will be in the future that really matters for central banks. A serious, prolonged, inflation undershoot does not seem to be in prospect because spare capacity in the economy is falling and is likely to continue doing so.

Unemployment is back to where it was in late 1997. Firms say they are operating well above normal capacity. Recruitment difficulties are high. There is still room to growth so inflation is not likely to take off. But equally the downward pressure is likely to fade from here on in.

To be even handed here, the pessimists would probably argue that inflation today shows there is really an enormous amount of slack in the economy. But if there were so much spare capacity that deflation was just round the corner, it is inconceivable that firms would be saying they were operating above normal capacity and were finding it hard to recruit the right staff.

Pessimists would probably also argue that the so-called neutral interest rate – the Goldilocks interest rate that makes the economy neither too hot nor too cold – is very low. Possibly even negative. This is one aspect of the now common secular stagnation argument.

There are reasons to believe the neutral rate is lower than it was before 2007, but the evidence does not support it being as low as interest rates are now. NIESR, the respected research institute, just estimated that the economy grew 3.6pc annualised in the first quarter of 2014. Interest rates are evidently not too high to stimulate growth.

Modestly below target inflation does not justify record low rates. Deflation and massive spare capacity would, but the UK is not anywhere close to deflation. In an environment of limited and falling economic slack and signs of above trend growth, the sensible course of action is to start raising interest rates in the next six months in my view. House prices are another justification. They are rocketing, and not just in London. The central bank will first try to deal with that by using credit rationing tools. But experience of those tools is mixed.

Monetary policy has got a recovery going. That is extremely welcome. The economy does not seem too far from normal capacity, inflation is not all that far from the central bank’s target, and growth is above average. Now is the time to dial the support back a notch to lower the risk of repeating the mistakes of the past.

Rob Wood is UK economist at Berenberg Bank and former economist at the Bank of England