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British Manufacturing Slumps as Bank of England Raises Interest Rates

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Tags Booms and BustsBusiness Cycles

An audio version of this article is available here.

On August 2nd, the Bank of England announced that its Monetary Policy Committee had unanimously voted to raise interest rates. This recent decision by Britain’s central bank saw its key ‘base rate’ of interest rise for only the second time since the 2007/8 crash. The 25 basis point hike brought the base rate up to 0.75%, its highest level since March 2009.

This is likely a reflection of the Bank of England’s growing confidence in the strength of Britain’s economy. Despite relatively slow GDP growth, Britain’s present record highs of employment had led to concerns that failure to tighten monetary policy would lead to “domestically generated inflation” through “excess demand”. Simply put, this refers to the widespread concern amongst mainstream analysts that maintaining low interest rates in a full-employment environment would induce employers to raise wages in order to attract scarce labour, which would in turn lead to price inflation when those workers start spending those extra wages. The Bank’s new rate hike is likely also intended to slow the pace of CPI inflation in the British economy, which has been consistently above the Bank’s 2% inflation target since the beginning of 2017.

The key place of interest rates in the framework of the Austrian business cycle theory lends a special significance to events such as this. This theory, developed by both Ludwig von Mises and F.A. Hayek, highlights the ability of central banks to stimulate unsustainable economic ‘booms’ by pushing down interest rates to artificially low levels. Although Austrians often focus on how low interest rates fuel the boom, the role of interest rate rises in triggering the ‘bust’ is equally important.

After a period of artificially low interest rates — such as the one the world economy has been experiencing for nearly the past decade — central banks will eventually have to slow down the printing press and raise rates again, to avoid plunging their currencies into severe inflation. When interest rates rise again, the marginal business ventures which had only appeared profitable at the previous, temporarily lowered interest rate, will now no longer find themselves able to remain in business at the new, higher cost of borrowing. While this effect does not always cause an immediate crash, the added strain of newly-raised interest rates will eventually necessitate a painful and widespread reallocation of resources away from the projects which had only been able to survive thanks to the previous period of temporarily low interest rates.

One of the most illuminating (and most often overlooked) insights of the Austrian business cycle theory is its recognition of the fact that producers’ goods industries — mining, manufacturing, metal refining, and other producers of capital goods — are hit particularly hard by this process. Due to their great temporal distance in the structure of production from the finished consumer goods market, these ‘higher order’ industries are particularly sensitive to changes in interest rates, causing them to swing upward most strongly in the boom, and crash hardest when rising interest rates bring about the eventual bust. If we are indeed coming to the end of the kind of boom described by the Austrian business cycle theory, we should be on the lookout for signs of the stress which this recent rate hike by the Bank of England will inflict on Britain’s higher order industries.

As it happens, this worrying process has already begun. On Wednesday 1st August, just one day before the Bank of England officially announced that it was raising interest rates, new data emerged which suggested that the British manufacturing sector had experienced a significant slump in July. This new data from the IHS Markit/CIPS UK Manufacturing Purchasing Managers’ Index (PMI) — regarded as amongst the most reliable indicators of business optimism — projects a decidedly downcast outlook for the manufacturing sector, which accounts for around 10% of Britain’s economy. The official PMI figures indicated that manufacturer confidence had sunk to its lowest level in 21 months, while the production of ‘intermediate goods’ used in the production of other goods also fell for the first time in two years. In addition to this, production growth fell to its lowest level in 16 months, and IHS Markit director Rob Dobson remarked that manufacturing had scarcely made any significant contribution to overall British GDP growth so far this year.

It is strictly speaking true that this July data represents the state of British manufacturing before the Bank of England raised interest rates on 2nd August, which has misled many analysts into pinning the blame on Brexit, Trump’s trade war, and other such contingent factors. However, it has for months been regarded as a near certainty that interest rates would rise in 2018, and financial markets in July were predicting a 90% chance that the Bank would raise rates on 2nd August, reasserting the likelihood that this was primarily a reaction to the imminent rise of interest rates.

Does all of this mean that the next great economic crash will be upon us tomorrow, next week, or even next month? Not necessarily. But it is a warning sign that a decade of near-zero interest rates and monetary expansion will not be without consequence. As central banks around the world continue to slowly raise interest rates, Austrians should pay close attention to the health of the world’s higher-order industries; they may well act as the canary in the coal mine, falling increasingly silent as the current boom draws to a close.

George Pickering is a 2018 Mises Institute Research Fellow and a student of economic history at the London School of Economics.

Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.
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