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Don't blame the Bank

Who sets interest rates? I ask because since Theresa May said that there have been “some bad side effects” of low rates, the Bank of England has been criticized for setting rates too low. These criticisms are wrong. One big reason for this is that interest rates are low largely for reasons beyond the Bank’s control.

Imagine the Bank of England didn’t exist and interest rates were determined by purely market forces. What level would they be? I’d suggest: very low, for several inter-related reasons:

- Demographics. Economists at the US Federal Reserve point out that an ageing population has caused labour supply to slow, resulting in a high capital-labour ratio that has forced down returns on capital and hence interest rates.

- A global savings glut. High net savings in many Asian countries, betokened by large current account surpluses, have driven down interest rates around the world.

- Weak capital spending. Whether this is due to slower technical progress or to a fear that current investments will be rendered unprofitable by future innovations, the result is the same: low demand for funds had bid down interest rates.

- Weak expected growth and/or high risk aversion. Eric Lonergan at M&G points out that, despite cheap money, the earnings yield on global equities is much the same as it was before the 2008 crisis. That’s a sign that investors are reluctant to hold growth-sensitive assets. Another symptom of this is the gap between the UK dividend yield and index-linked yields. For most of the 80s and 90s, this was between 0.5 and one percentage points. Recently, it’s been above five percentage points. This is a sign either than investors expect slow growth in dividends and/or that they are loath to hold risky assets. Either implies that returns on cash should be low, as investors crowd into safe assets.

- High liquidity preference. UK retail customers have over £1.5 trillion of deposits in banks, a rise of 28 per cent in the last five years. This indicates a strong demand to hold cash, which would force down rates even without the Bank’s intervention.

Interest rates then are low around the developed world not because of a mistaken groupthink by central bankers as William Hague alleges, but because of fundamental market forces - the things that led Larry Summers to revive the phrase “secular stagnation.”

Yes, the Bank could jack up Bank Rate. But if it did so in the face of these forces, market-determined rates - gilt yields - would stay low because investors would anticipate even weaker growth. The Bank would then find itself in the position of King Cnut, powerless in the face of the forces of the tides.

None of this is to deny that low rates do indeed have unpleasant effects: it’s possible that they might eventually lead to excessive risk-taking, bubbles and financial instability although it’s unclear whether they are doing so yet. What it does mean, though, is that the Bank isn’t to blame for these dangers.

Nevertheless, there is something policy-makers can do. A looser fiscal policy would tend to raise aggregate demand and offset the forces for secular stagnation. That would tend to push up interest rates giving us what I believe would be a healthier mix of monetary and fiscal policy. The solution to the problem of low interest rates, therefore, lies closer to Ms May’s door than she believes.

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By Chris Dillow,
31 October 2016

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Chris Dillow

Chris spent eight years as an economist with one of Japan's largest banks. Here, he provides insightful commentary on the latest economic news and data, along with thought-provoking articles about investor behaviour.

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