Thursday, 16 June 2022

Doves, Hawks and the Politics of Interest Rates

Everything is political. 

This phrase annoys me. It is often used as a way for people to steer the direction of an argument towards something they would prefer to talk about: politics. 

For example, how do interest rates affect inflation and unemployment? Of course this question has political ramifications, how can it not? And yes, people's views on this will be affected by political bias. But at some point, moving interest rates up or down may actually do something to these variables and maybe, just maybe, that is an interesting question in itself?*

But in this case I actually want to talk about the politics of interest rates. I was partly inspired to write about this by the rather odd statement from Andrew Bailey suggesting workers shouldn't ask for pay rises in response to inflation. But also because I think the Left vs Right view of interest rates is misguided.

I have written a brief explainer about how we think interest rates work but feel free to skip the next section if you are au fait with monetary policy.

Intro to Interest Rates

Interest rates are the tool most modern economies use to control inflation and unemployment. You may be aware that the UK has a target rate of inflation of 2%. What you may not realise is that they also target unemployment implicitly (the US they are explicit about this in the Fed's target and state it as a 5% unemployment rate).

This is due to the view that there is a trade-off between inflation and unemployment, AKA the Phillips curve. 

Imagine an economy where unemployment is high that there is a surge in demand for new goods. Firms will hire people who are unemployed to meet this extra demand and so there is no real pressure for prices to increase.

But what if very few people were unemployed and demand increased? Prices are likely to increase in this case. The only way firms could get people to make these new products is by hiring from other firms or ask people to work more hours. But in order to do this, you need to increase wages. But increasing wages means people have more money to spend and this increases demand for products further, so firms increase prices again. This is the so called wage-price spiral.

So in order to control inflation, central banks increase interest rates in order to encourage saving rather than spending. This takes some of the demand out of the economy and so firms won't need to find workers and raise prices to meet this demand. 

If unemployment is high, however, we don't expect much demand in the economy and so expect inflation to be low. The central bank would seek to cut interest rates to discourage saving and increasing spending so that firms will employ more workers.

Doves vs Hawks

Being a "Dove" on interest rates entails caring more about unemployment than inflation, so you would be less likely to increase interest rates with signs of inflation. This is often associated with being more Left-wing. Being a "Hawk", is the opposite, caring more about inflation than unemployment and is usually associated with being more Right-wing. 

The historical reason for this political alignment is probably easiest to think about in a rich class (Right-wing) vs poor class (Left-wing) way. 

Poorer workers are more likely to be unemployed or become unemployed, so should intrinsically care more about unemployment. They also have have very little savings or assets which is aversely affected by inflation. 

For example, if  inflation was 100% and I were on £10 an hour and had zero in savings, then due to the demand present within the economy (so the theory goes) I would be able to get a wage rise in line with inflation to £20 an hour. Capitalist get most of their income via assets rather than labour, so if they had £1 million in savings then 100% inflation would mean they would affectively lose £500,000. So in this case the rich have far more to lose from inflation than the poor.

The first issue I have with this is that (in the UK at least), wages are not currently rising with inflation. There are number of reasons for this that we know of, not least the decline in unions and bargaining power of workers. But also that inflation is being driven in quite a large way by supply-side issues, through energy prices, Covid in China and the war in Ukraine. So the standard demand side view of inflation (as described in the previous section) isn't really the dominant factor in what is happening. What this means is that inflation is hurting both poor and rich alike. And although it may affect the rich proportionally more, the poor are less able to cope with inflation - hence, the cost of living crisis.

The other issue I have is that the rich also care about unemployment (not in a benevolent sense). By this, I mean the rich care about demand in the economy. If you are a big fat cat capitalist, you actually want people to go out and buy your wares. Unemployed people tend to not have very much money, so from a purely selfish point of you, the rich want you to be employed. So even though they may care about inflation more than unemployment, economy-wide unemployment is still bad for the rich.

I have only touched upon the politics of interest rates in so far as how they affect inflation and unemployment. But interest rates have a politics of their own. Home-owners (who tend to be richer) would want to keep interest rates low so they don't have to fork out so much in your monthly mortgage repayments. If you are saving up for a deposit for a house you would most likely benefit from higher interest rates in your savings account. 

The thing is, people don't always fall neatly into the above classes. Each individual will likely have their preferences depending on the make up of their wealth, the type of job they do and age etc. It might be true that on average that a Doveish stance may be slightly more pro poor and Hawkish more pro rich. But I would say this average has a lot of variability. I would also argue that these preferences are not absolute e.g. I may care more about unemployment than inflation, but this all depends on how high inflation is!

Andrew Bailey's Political Intervention

Saying all this, I do find it rather odd that Andrew Bailey suggested you shouldn't ask for a wage rise in response to inflation. What he implicitly said here was don't ask for raise or else we will have to increase interest rates further. If he said that a rare rise would be a consequence of increasing wages then fine (even though increasing wages isn't the main cause of inflation this time around, it will not exactly help bring inflation down).

But by explicitly arguing that people should not ask for a wage rise isn't in the governors remit. I would even go as far to say that it is a political intervention**. For many people (especially those on low-income with few assets), a wage rise would be in their interest, even if it contributed to higher inflation. He needs to take what people do as given, and respond with interest rates accordingly.

* "But ignoring the politics of this question is political!" you say, steeringly.

** When Mark Carne talked about Brexit uncertainty and was also accused of political intervening. To my mind, this is quite different. He was not telling people what to do or even suggesting Brexit was wrong. You could argue his political bias affected his reasoning but then you go down the everything is political rabbithole.

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