Economies hooked on central bank stimulants?

Three years ago Andrew Sentance was one of the 9 members of the MPC who voted for the extraordinary measures of bringing base rate down to 0.5% and creating the new stimulant of Quantitative Easing in an attempt to bring the economy around. In today’s Sunday Telegraph he recalls why he voted for them at that time, and explains why he thinks that they must be gradually withdrawn now from an economy which has become dependent on them for its survival.

He acknowledges the difficulty that rising rates would cause for borrowers (some mortgage lenders are taking matters into their own hands by raising rates this weekend anyway) – but considers the painful effect on savers of the combination of low rates and high inflation, as real interest rates cause the value of their interest returns to be negative. More significantly, he considers the way in which low rates have maintained a weak pound; this he sees as a significant factor in keeping cost-push inflation high for an economy which imports so much of its raw materials and finished goods.

Andrew Sentance is known to have voted for the rate to be raised again while he was still a member of the MPC (he stepped down from the committee last May), and in this article he explains his reasoning: “A greater willingness on the part of the MPC to combat rising UK inflation with higher interest rates in late 2010 and early 2011 could well have dampened the recent surge in inflation through its effect on the value of sterling.”

He draws support from a recent speech by Paul Tucker, Deputy Governor of the Bank of England, to the Society of Business Economics in which he spoke of the importance of being “alert to the need to withdraw stimulus as and when recovery builds”. Mr Tucker also warned that current monetary policies “could sow the seeds, somewhere in the financial firmament, of the next set of imbalances”.

Sentance worries about economies and investors becoming hooked on the stimulus programmes of central banks, and unable to support economic growth on their own. He is concerned that if a gradual managed withdrawal programme is not started, then sooner or later a ‘cold turkey’ programme of significant rate rises will become necessary, which will cause strong negative shocks to both consumer and business confidence. His view is supported by an article in the FT (“Investors crave new shot of stimulus”).

How long can an emergency measure stay in place before it becomes part of the normal economic landscape and a prop which is necessary for the long term? Should we accept now that over the last four years the economic landscape has changed in a way that justifies a long-term change in the way that economic policy tools are used? Or will the cycle eventually reassert itself somehow?