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Why rates will stay low

Created:

29 June 2009

Written by:

Chris Dillow

Next week's meeting of the Bank of England's monetary policy committee might have to face the question: what to do about the possibility that the economy might be recovering? The answer is probably: nothing. Even if the recovery does take hold - which is far from certain - Bank rate could stay low for some time. There are nine reasons for this.

1. Inflation usually falls as the economy recovers. Take the last two recoveries from serious recession. After the 1980-82 recession, inflation, as measured by RPIX, didn't bottom out until the first quarter of 1984 - 18 months after real GDP bottomed out. After the 1990-92 recession, inflation troughed in the summer of 1994, over two years after the economy bottomed.

This suggests that even if the recession is now over, inflation could keep falling until mid-2011. Which means that it should be below its 2 per cent target in late 2011 and early 2012. Because Bank rate is set with regard to where inflation will be in two years time - as it takes that long for monetary policy to significantly affect prices - this points to rates staying low for at least a few more months.

2. Output will stay below potential. One reason why inflation falls as the economy recovers is that output is below its trend level early in recoveries, and this spare capacity causes companies to hold prices down.

And this output gap could stay big. The Treasury has estimated that GDP was 2 per cent below trend at the end of last year. If we combine the Bank of England's median forecasts with the Treasury estimate of trend growth (2.75 per cent a year), this implies that output will be almost 10 per cent below trend at the end of 2011.

This is perhaps an overstatement, as the Bank's forecast might be too pessimistic and the Treasury's estimate too optimistic. But almost any reasonable numbers tell us there will be a big output gap for some time to come. Which should hold interest rates and inflation down.

3. The banking crisis hasn't passed. The CBI reported recently that banks are still tightening lending standards to companies, and Bank of England figures show that lending to non-financial firms has fallen in the past two months. This picture might not improve quickly. Banks' capital ratios are still not high and they could weaken as the losses on loans turned bad by the recession become evident.

Against this background, rises in Bank rate would be dangerous. In raising Libor - the cost of funds to banks - this would threaten a further decline in lending.

4. Unemployment usually rises in the early stages of economic recovery. This could be especially true this time, if financing constraints limit the ability of healthy companies to expand.

Now, high unemployment in itself has only weak implications for inflation; the Phillips curve is ill-defined, although Bank economists believe it does exist if you torture the data sufficiently. But it would be politically awkward to raise rates much when unemployment is high and rising - and economically awkward too, insofar as high unemployment was a symptom of a weak banking system and wobbly recovery.

5. Overseas economies are in poor shape. Official figures show that in the past three months industrial production has fallen by 3.6 per cent (an annualised rate of 13.7 per cent) in the US, by 4 per cent in France, and by 4.9 per cent in Germany.

Such weakness in our main trading partners will hold back our economy, not only by limiting exports but by depressing business confidence and capital spending.

What's more, inflation is increasingly influenced not just by domestic economic activity but by the global economy. Weakness in this means low import prices and hence low UK inflation.

6. Sterling has strengthened. Another reason to expect import prices to fall is, of course, that sterling's trade-weighted index has risen 10 per cent since mid-March.

This itself represents a tightening of monetary conditions. Back in the 1980s and early 1990s, economists had a rule of thumb that a 4 per cent rise in sterling was equivalent to a 1 per cent rise in Bank rate. The Bank of England no longer believes this. But the vaguer point holds - that a rise in the pound squeezes prices and output and therefore does some of the work of rising interest rates. Which means rates don't have to rise.

7. Fiscal policy will have to tighten. It's not just the rising pound that does the same job as rising rates. So too, arguably, does fiscal policy. Most people - the prime minister excepted, apparently - believe that taxes will have to rise and/or public spending fall after the next election. This would at least threaten to hold back economic activity. So rates will have to stay low to accommodate this.

8. Monetary growth doesn't much matter. The most obvious argument for raising rates is that the money stock is soaring. The M4 measure - bank and building society deposits - has grown 16.6 per cent in the past 12 months. However, most of this growth is due to a 50.6 per cent rise in the cash holdings of non-bank financial institutions. The monetary measure which most concerns the Bank - the M4 holdings of households and non-financial companies - has risen just 2 per cent in the past 12 months, which is too low to generate inflation.

9. Insurance. In July 2003 the Bank cut rates even though the economy was pulling out of a mild downturn. It did so because it wanted to take out insurance against the threat of deflation. Similar concerns might weigh on the Bank even if the economy does recover. The possibility of a 'double dip' recession, or simply of anaemic growth, are likely to outweigh the risk of a sharp rise in inflation. The balance of risks, then, seems to point to rates staying low for insurance purposes.

It seems, then, that there are good reasons to expect the Bank to keep Bank rate around 0.5 per cent for some time. But financial markets are not convinced by these arguments. Short sterling futures are pricing in a three-month Libor of 3 per cent, a rise of 1.8 percentage points from current levels. Could it be, then, that the market has overreacted to signs of recovery?

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