Yesterday the Bank of England announced it would hold interest rates at 0.5% to curb inflation. UK growth for 1Q 2010 is estimated to be 0.3%, while inflation was about 3.4% (CPI) or 5.1% (RPI) in May. The target rate is 2.0%, but does the BoE really believe the fragile British economy can stomach this?

It is certainly more responsible to hold the interest rate rather than decrease it. Still, there is a fundamental inefficiency in monetary policy. I’m aware not everyone advocates an Austrian style free banking system as I do, but the problems with using monetary policy as a stabilizing mechanism are nevertheless important and undeniable.

As you can see in the graphs below, the BoE used an active approach to the recession: it decreased the rate when the economy was contracting. A decrease in interest rate increases the money supply and causes inflation if there is little economic growth. Monetarists like Milton Friedman therefore suggested an inflation rate equal to real GDP growth. Friedman also showed how the distribution of inflationary monetary policy creates real wealth misappropriation with his famous helicopter example.

Other inefficiencies are more practical. By the time any institution gathers and collects statistics, negotiates rates, and finally acts, the statistics have already changed. There is then a further lag on the influx or outflow of available credit throughout the whole economy. Even with today’s technology, it is impossible to structure a utopian credit structure just as it is impossible to structure a perfect economy.

It is interesting how quickly almost every other price in the economy adjusts to economic storms. Why is an interest rate subject to supply and demand so mistrusted? The intentions may be angelic, but the nature of the BoE setting interest rates exaggerates the business cycle. After all, the road to hell is paved with good intentions.