Bank under fire over UK interest rates

Has the MPC over-estimated inflation?

by Steve Schifferes BBC News Online economics reporter

A leading member of the Bank of England's interest rate-setting body has said that interest rates could have been kept lower without any danger of inflation.

Dr Sushil Wadhwani, who leaves the Monetary Policy Committee (MPC) at the end of the month, said that the committee had consistently over-estimated the threat of inflation.

Wadhwani: Growth could have been higher

His research suggested that if interest rates had been lowered by 0.25% over the last two years, the Bank would still have hit its symmetrical inflation target of 2.5%, but growth would have been 0.5% higher.

As it was, inflation has been lower than the Bank's target in 34 of the last 36 months.

The MPC is charged with keeping inflation within one percentage point either way of the 2.5% target.

Help for industry

Industrialists and unions have long complained about the effect of high interest rates on their prospects, and Dr Wadhwani said that it was vital to the Bank's future credibility that it made more accurate estimates of the inflationary threat.

A clear signal from policymakers that they would react to a (housing market) bubble if one emerged would make the continuance of strong house price growth less likely now

Sushil Wadwhani, MPC member

Mr Wadhwani said that the problem was that the Bank of England's economic forecast, which the MPC uses to forecast inflation over the next two years, was out-of date.

The new decision-making framework itself had reduced the threat of inflation from higher wages or external shocks such as a rise in the exchange rate.

Among those listening to Mr Wadhwani was Bank of England chief economist Charles Bean, whose job it is to prepare the forecasts.

House price bubble

However, Dr Wadhwani did warn that the Bank of England may have to take action relatively soon to curb the house price bubble.

He said that the current rate of increase in house prices was not sustainable, and would soon lead to the ratio of house prices to average earnings reaching unacceptable levels.

"A clear signal from policymakers that they would react to a (housing market) bubble if one emerged would make the continuance of strong house price growth less likely now," he said.

Dr Wadhwani is a strong believer that early action by the MPC on "asset bubbles" can help smooth the path of inflation, and had expressed previous concerns about the high stock market prices in the tech sector.

This view is still controversial, both within the Bank of England and elsewhere.

The Federal Reserve in the US made attempts to warn investors about the "irrational exuberance" of the stock market, but in the end cut interest rates sharply, partly to prevent sharp falls in the market.

Budget puzzle

In his final parting shot, Dr Wadhwani also took issue with the MPC over its assessment of the recent Budget.

The MPC's latest inflation report has warned that the big increase in public spending signalled by Mr Brown could be inflationary, even if it was mostly paid for by higher taxation.

The report says that the increased National Insurance contributions could lead to higher wage demands, and that the extra public spending would not be fully offset by cuts in private sector demand.

But Dr Wadhwani argues that there is no evidence for a "balanced Budget stimulus" and that higher public investment might result in potential improvements which would make the economy more efficient, and less prone to inflation.

After Dr Wadhwani, leaves the MPC, it is not clear whether such "dovish" views will be as strongly represented.

His successor, economist Marion Bell, is expected to be a mild inflation "hawk".