UK and US monetary policy - designed in Monaco

The Sunday Times shadow MPC is voting for a rate hike in the UK. It won't make a blind bit of difference, what we will get instead is a bit of tinkering with the forward guidance the MPC use, to lower the rate unemployment needs to fall below before they will contemplate rate hikes.

The UK rate debate is echoed in the US, though it seems more vociferous here, and centres around the question of whether it is interest rate changes that matter, or the level of interest rates.  If you ever play with monetary policy rules, like the Taylor Rule, they will suggest appropriate rate levels, rather than moves and will definitely suggest that rates should be raised even when inflation is low. Their starting point is that there is a 'neutral interest rate' from which actual rates should differ as a function of how much slack there is in the economy and how far inflation is from target.

A standard Taylor rule estimate would put UK interest rates around 2% at the moment, on the basis of a 6 1/2% NAIRU and a 2% inflation rate target. Core CPI inflation is just below target and unemployment is not that far above target, so a real interest rate a little above zero would seem to make sense. You need to get NAIRU under 4% to justify current policy rates. That's even lower than the US (NAIRU at 4.3%) and of course far lower than the level of NAIRU which justifies current rates in Europe (around10%).

The Taylor rule isn't the holy grail of policy making, and it's certainly being ignored by central banks at the moment; but should rates to be kept at current (extraordinarily low) levels just because there is slack in the economy? On that basis, rates would be far below 'neutral' until there was no slack in the economy, or until growth was consistently above trend, and then they would have to rise very fast. It's the equivalent of keeping your foot hard down on the accelerator of a car until it's time to brake equally hard - more like how you might drive an F1 car round Monaco than a Ford Fiesta round Islington.

Setting rates too far from 'neutral', however that's measured, causes mis-allocation of capital. By keeping rates too low for too long a decade ago, the Fed provided the fertiliser that allowed the credit bubble to blossom so disastrously.  There are times when extraordinary monetary policy makes sense, but I'd like to see a return to rate levels that are higher, but still very low relative measures of 'neutral', as soon as it is safe to do so. So the question now, is whether it's 'safe' to take baby steps in the direction of nomalising policy, not whether it's time for policy to be 'tightened'?

For now,  the debate (in the UK and the US) is about whether rates should be raised or not, rather than whether they are at appropriate levels for economies with falling unemployment and above-trend growth rates. That's a  mindset which is friendly for asset prices and even if there is little risk that we see any significant upward pressure on either wage growth or inflation, it will continue to cause capital to be misallocated.