Have Mervyn King and his colleagues been shilly-shallying over interest-rate hikes? Has the Bank of England's monetary policy committee been excessively timid?
Yes, according to Paul Mortimer-Lee, head of market economics at BNP Paribas, who accuses the Bank of reinflating the housing-market bubble with its gradualist approach to interest rates. The three modest rises over the past six months have encouraged consumers to think that rates are not going to rise very far or fast. So they also think they can borrow more, stretch themselves to afford that home, remortgage to buy that car or cruise, yield to another tempting credit card offer. Compare the Reserve Bank of Australia which, with its more aggressive tightening of monetary policy, has virtually stopped the housing-market boom there in its tracks.
Mortimer-Lee's criticism in the letters page of the Financial Times has reignited a debate known among economists as the frog-boiling question. Frogs in gradually heated water don't realise they are being boiled to death. Frogs dropped straight into boiling water jump out and save themselves. Similarly, consumers facing gently rising interest rates do not adjust their behaviour. Consumers confronted with shockingly big hikes do. That's the theory, anyway.
But it is one that no one on the Bank's nine-member monetary policy committee subscribes to. Quarter-point movements are the order of the day, and then usually only when the City has already forecast them. The only dissenter was Professor Willem Buiter, who for a while in the late 1990s pushed for gigantic changes in rates. But he has long since left the committee. The other day, the Bank's arch-frog-boiler, Governor Mervyn King, expressly rejected the idea of making big changes in order to be noticed. "The aim isn't to go out there and do something unexpected just to kick up a bit of fuss and get a bit of publicity; that's exactly the opposite of what we're trying to do. The aim is to have a clear framework so people actually have some understanding of what we think about the economy and how we're likely to react."
You can see his point: if people anticipated interest-rate changes more, they would modify their behaviour in advance, ultimately making the need for the actual interest-rate changes less great. Every interest-rate cycle would be less extreme than the last, until we reached monetary nirvana of constant base rates. Perfectly informed, perfectly disciplined borrowers would adjust their behaviour, the MPC could disband itself, and there would be none of that agonising about whether to opt for a fixed or variable mortgage.
The question remains whether, in this very imperfect world, consumers need more of a jolt. The Council of Mortgage Lenders, the trade body for banks and building societies, has reportedly claimed that we need to double the base rate if the housing boom is to be tamed quickly. Michael Coogan, the council's director general, said it might already be too late for the MPC to influence the housing market with "small tweaks". He later modified his remarks in the wake of the predictable explosion from the Treasury.
It may be, as DeAnne Julius, another former MPC member, has suggested, that lenders are merely trying to shift blame for any future housing bust from themselves to the Bank. But there is no doubt that larger hikes are now on the agenda. Indeed, the MPC discussed a half-point rise earlier this month.
The Bank's difficulties are exacerbated because its only aim is to keep inflation as close as possible to 2 per cent. It is not directly concerned with the housing market, even though house prices'
influence on consumer behaviour is so big.
The psychology of interest-rate changes is desperately hard to model. Factors such as job prospects and security and local house-price changes are much more important in influencing behaviour. King may have got things spot on. The seeds of a borrowing and consumption slowdown are already in place, he argues. The cost of debt payments as a proportion of household incomes will go up from 10p in the pound today to 14p next year just from rate rises already in the system. That may be enough to get people and firms to curb their spending, cut their borrowing and increase their saving. But the Bank has consistently been wrong-footed by the housing market and may still be underestimating its energy.
To switch from a frog-boiling to a nautical metaphor, it is surely better,
when trying to turn around a supertanker,
to make bold moves on the tiller initially and then more cautious moves once the ship is well into its turn. The danger of starting off tentatively is that if nothing much seems to be happening - as is the case now - the decision becomes harder. Do you now make a big move, or do you worry about panicking at just the wrong moment, causing you to overshoot?
The MPC must be sweating a bit on the bridge at Threadneedle Street.