Monday, February 01, 2010

Higher or lower? The Tories, interest rates and the pound

As Chris reports, George Osborne has said: “The overriding objective of fiscal policy must be to provide the credible deficit reduction plan that allows the Bank of England to keep mortgage rates as low as possible for as long as possible.” He’s been pushing this view for a while.

In an intellectually hefty (by his standards) speech in September, Osborne said that “tight fiscal policy will allow the independent MPC to keep interest rates as low as possible for as long as possible while keeping inflation and inflation expectations securely anchored”. He also dealt directly with the argument that significant spending cuts too soon could such demand out of the economy and put the recovery at risk:

Not only does this argument ignore the risks of a loss of confidence and higher interest rates, it is also too simplistic. It ignores the impact of fiscal policy on the exchange rate in an open economy like the UK. Ben Broadbent, Chief UK Economist at Goldman Sachs, wrote recently that fiscal tightening in an open economy "has little appreciable impact on aggregate output" because it tends to rebalance demand away from non-traded goods and services and towards the traded sector. In other words, what you lose in government spending, you gain in exports.

The Goldman paper doesn’t seem to be online, but Stephanie Flanders has summarised its gist:

If the government… announced tighter budget plans starting in 2010, it is possible that the bond markets would reward that government by pushing down long-term interest rates (also known as the interest rate on government debt). That could stimulate the economy in its own right by making it cheaper for companies to borrow. It could also, by reducing the return on sterling investments, push down the pound, giving an extra fillip to exporters.

So, if I understand this right, the tighter fiscal policy that the Tories are planning (as Cameron says, “We're not talking about swingeing cuts”, which I believe to be literally true) will mean that monetary policy can stay looser for longer.

It will also push the value of the pound lower than it would have been, which will help exporters. This will also make imports more expensive, which will drive up inflation. But that will mean higher interest rates, which is exactly what Osborne wants to avoid.


Then there’s the effect on the cost of government borrowing. If foreign buyers of UK gilts think that the pound will be lower in the future, then they’ll demand higher yields to make up for this – thus pushing up the cost of public borrowing.

Bill Gross, of fund managers Pimco, has been sounding the most lurid warnings lately about UK public debt and the gilt market. He said last week: “High [UK goverment] debt with the potential to devalue its currency present high risks for bond investors.” He’s in favour of fiscal consolidation, but so that the government doesn’t take on more debt than it can safely service, not in order to get the currency down – quite the opposite, as he seems to imply that a government that cuts its borrowing will be rewarded by a stronger currency.

So do the Tories really want a lower pound? Do they know how to bring it about? Do they want the consequences that flow from it? I confess I struggle to understand the rationale here. Perhaps it’s because I’m a bumbling amateur when it comes to economics and finance. Or perhaps it’s because Osborne is too.

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