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OPINION

Why interest rates are low

Why interest rates are low
April 22, 2014
Why interest rates are low

To see why, let’s start from a textbook theory of what interest rates should be – the Taylor rule. This says that Bank rate should be equal to the inflation rate multiplied by 1.5, plus the output gap multiplied by 0.5, plus a constant to reflect what a “normal” interest rate should be. With CPI inflation at 1.6 per cent, and the Bank estimating that the output gap is 1-1.5 per cent, this implies that Bank rate should be around 2.7 per cent, if we assume that a “normal” real rate is two per cent.

But of course, monetary policy is looser than this – very much so if we take account of quantitative easing. The Bank of England has estimated that its first £200bn of QE was equivalent to a cut in Bank rate of between 1.5 and three per cent, implying that the £375bn of QE is equivalent to a cut of around 4.2 percentage points in Bank rate. This tells us that a “QE-adjusted” Bank rate is around 6.4 percentage points lower than the Taylor rule predicts.

What can explain this difference?

Obviously not inflation or the state of the economy; these are captured by the Taylor rule.

One possibility is that the Bank is still taking out insurance against the possibility of a renewed financial crisis. It fears that raising rates would plunge the minority of highly-geared households and companies into bankruptcy, which would lead banks to curtail their lending even to healthy firms.

Another possibility is that we’ve entered an era of secular stagnation, in which trend economic growth is so weak as to warrant a negative real interest rate.

These two factors, though, are unlikely to explain all the gap between Bank rate (especially if adjusted for QE) and the Taylor rule’s prediction. But something else can – fiscal policy.

The Taylor rule assumes that monetary policy is the only macroeconomic policy that changes. But this is not the case now. The government plans on tightening fiscal policy more in coming years; the OBR envisages cyclically-adjusted net borrowing falling from 4.3 to 1.7 per cent of GDP between now and 2016-17. To offset this tightening, monetary policy should be looser than a Taylor rule predicts.

How much looser? That depends upon two things: the impact of a fiscal tightening upon GDP; and the extent to which low interest rates boost GDP.

The IMF has estimated that fiscal multipliers since the recession have been in the range 0.9-1.7. If we take the lower end of this range, we can say that the fiscal tightening between now and 2017 will take 2.6 per cent off GDP.

What sort of monetary easing would offset this? One clue comes from the Bank of England’s “Compass” model of the UK economy. In this, a one per cent cut in interest rates raises GDP by around half a per cent at its maximum. This implies that we need a cut in interest rates of around five per cent to offset a fiscal tightening of 2.6 per cent of GDP.

This five per cent is equivalent to most of the gap between the Taylor rule’s prediction and the present level of Bank rate, adjusted for QE. This tells us that it is fiscal policy that is largely to blame for low savings rates.

Now, it doesn’t follow that the government is to blame. Even those of us who suspect that big deficits are sustainable for longer than the government believes – because the savings glut, shortage of safe assets and secular stagnation mean that the state can borrow cheaply – would be uneasy if fiscal policy didn’t tighten at all. This is because the deficit is so big that they would raise the debt-GDP ratio, which would present problems of intergenerational justice if nothing else.

What it does mean, though, is that it is not just public sector workers who will continue to pay the price of fiscal austerity. Savers will too. I’m surprised this isn’t more widely appreciated.