Should we carbonize interest rates?

This morning, the radio bulletins are full of speculation about interest rates. The Bank of England Monetary Policy Committee (MPC) meets today to decide whether to change the Bank’s base rate from the current 5.75%. With the financial world in a lather about the credit crunch, the betting is that they will cut by 0.25%, though some are so desperate they are hoping for a 0.5% cut.

Yet the MPC’s brief is not to respond to financial crises. It is charged with just one task, which is to keep a lid on inflation, and inflation is currently above its target range so they really should be considering raising rates, not cutting them. It’ll make for a very intriguing meeting. And it also neatly exposes a conundrum at the heart of government policy. Why track only price inflation? And how exactly do you measure inflation anyway?

It seems to me that there is both good inflation and bad inflation. Or to put it another way, not all prices rises are inflationary, as they may simply cause demand to fall. An example of good inflation is oil going up in price: recently it’s been nudging a headline grabbling $100 a barrel. Surely the world is a better place with high oil prices, as it sends a strong signal to us to stop burning quite so much of it, and to start looking for alternative ways of creating energy. So why should we be hit with high interest rates because the oil price is high?

Following on from this, I have been thinking that maybe the MPC’s target should be modified. Carbonized even. Instead of just looking at a theoretical basket of prices (a haphazard undertaking at best), should it not start considering fossil fuel use as well? Or even instead? How would it work?

The target for carbon use would have to be negative, say 3% less each year. Provided the country meets that target, then interest rates would be set breathtakingly low, encouraging zero carbon growth. On the other hand, if the country as a whole fails to meet the target, then the MPC would raise interest rates so as to dampen economic activity, if necessary pushing us into recession (which is reckoned to be the single most effective brake on carbon use yet devised). Stiff medicine maybe. But isn’t that what we need?