To see what I mean, take two perspectives.
The first asks: what has usually determined Bank rate in the past? You'd expect it to be inflation and real economic conditions. And you'd be right. My chart shows that between 1989 and August 2008 (just before the collapse of Lehmans) four-fifths of the variation in Bank rate was explained simply by annual changes in consumer prices and in manufacturing output; the dotted red lines in the chart are one standard error either side of the prediction yielded by these two variables*.
However, these factors are utterly unable to explain why Bank rate is at 0.5 per cent now. With CPI inflation at 3.1 per cent and manufacturing output five per cent higher than a year ago, 1989-2008 relationships say that Bank rate should be around 9 per cent. We are more than five standard errors short of that.
The second perspective is to use a Taylor rule. This says Bank rate should depend upon the inflation rate and the output gap, the deviation of GDP from its trend level. If we calibrate this so that a zero output gap and on-target inflation gives us a real Bank rate equal to trend GDP growth - which the Office for Budget Responsibility estimates to be 2.25 per cent - and if we take the OBR's estimate of the output gap this rule says Bank rate should be just over 4 per cent now**.
All this raises the question. What can justify Bank rate being so far below what both theory and past relationships predict?
One obvious possibility is that inflation is artificially high, having been raised by the restoration of the 17.5 per cent VAT rate in December. It would be odd for the Bank to mechanically raise Bank rate in response to higher VAT, which is what our two relationships imply it should do.
A further possibility is that the economy is weaker than five per cent output growth or a sub-four per cent output gap imply.
These arguments are not strong enough to eliminate all the gap between actual and predicted Bank rate. From our first perspective, we'd need zero inflation and a five per cent fall in output to warrant a 0.5 per cent Bank rate. And the Taylor rule tells us that if inflation were two per cent, we'd need a 7.5 per cent output gap to justify a 0.5 per cent Bank rate. But it's highly unlikely that the gap is this big. If it were, unemployment would be higher than it is and inflation would be falling faster than it is.
So, we need some other explanations. Here are three non-exclusive possibilities.
1. Trend economic growth is even lower than the OBR's 2.25 per cent estimate. And the lower is trend growth, the lower should be interest rates. On its own, though, we would need a very low growth rate indeed to justify a negative real Bank rate.
2. The Bank of England is taking out insurance against the risk of a sharp downturn. It's easy to see the dangers. Maybe cuts in government spending will depress aggregate demand. Maybe companies will reverse their recent accumulation of inventories. Perhaps consumer spending will falter under pressure from the squeeze on real incomes. Or perhaps fiscal tightening overseas will hit our exports.
There is, though, a problem here. The risks to the economy were probably even greater in 2008-09 than they are now. There were, remember, serious concerns about a full-scale meltdown then and fears that unemployment would exceed three million. However, the degree of insurance the Bank is taking out - measured by the gap between actual and predicted Bank rate - is greater now than it was then.
3. The monetary transmission mechanism is broken. Before 2008, a 0.5 per cent Bank rate would have created the mother of all lending booms. Today, with banks unable or unwilling to lend, and consumers and firms unable or unwilling to borrow, there is much less danger of this. The Bank can afford to have a low rate.
This explains why our first perspective predicts what seems to be a high Bank rate. In the 90s and 00s, the real interest rate had to be high to constrain borrowing and encourage saving. Today, it doesn't have to be. The "natural" rate of interest - the one which brings desired savings into line with planned borrowing - has fallen.
There's an obvious implication here. As long as credit growth remains depressed, freakishly low interest rates are sustainable. And there's no sign yet of such growth recovering. Lending to individuals hasn't grown at all in the last two months, and lending to non-financial companies has fallen.
This suggests that Bank rate can remain low for some time. However, because it is so far from any "normal" level, it is possible that if or when credit growth does recover, Bank rate could rise quite sharply.
* The regression equation is: Bank rate = 2.38 + (1.52 x CPI) + (0.39 x manufacturing output).
** The equation I'm using is Bank rate = 1.25 + (1.5 x CPI) + (0.5 x output gap).
