There is, though, a risk in this strategy, pointed out by Ruth Lea at Arbuthnot. If the economy recovers faster than expected, she says, interest rates would have to rise sooner than the Bank has guided us to expect. Such a move would weaken the Banks’ credibility. That wouldn’t just put egg on Dr Carney’s face. It would also make it harder to issue guidance in future, because it wouldn’t be believed.
This suggests that the Bank should only guide us to expect rates to stay low if it strongly believes economic conditions will justify such low rates. Which poses the question: under what circumstances can real interest rates stay negative for a long time?
Common sense tells us that the expected return on an asset will be low when it is in high demand. The question: “how can rates stay low?” is therefore equivalent to asking “how can demand for cash stay high?” (I am here trying to ignore the argument between Keynes and the classical economists about interest rates).
There’s little doubt that demand for cash is high. Bank of England figures show that in the last 12 months non-financial companies have increased their bank deposits by 7.3 per cent whilst reducing their debt by three per cent. And households have raised their deposits by 5.1 per cent whilst increasing debt by just 0.7 per cent. But why might people want to continue to hoard cash? There are (at least) three possibilities.
- Companies will continue to be loath to invest, preferring to build up their cash piles. This might be because uncertainty about the euro area will continue; or because corporate sentiment will stay depressed; or because the dearth of investment opportunities we’ve had since the early 00s will continue.
- Households will want to rebuild their balance sheets, by saving more or paying off debt. This process has not yet begun. As the TUC’s Duncan Weldon points out, the households’ savings ratio has fallen recently, as people try to maintain their spending during the squeeze on real incomes. There’s a danger that, when real incomes start to recover, households will use the spare cash to save more or reduce debt.
- Among savers, the income effect will offset the substitution effect. The impact of low interest rates upon cash-rich households is ambiguous. On the one hand, they should encourage us to spend more; with the return on savings so low, we should substitute towards spending instead. But on the other hand, lower interest rates reduce our income. If we have a target level of wealth (say because we’re saving for retirement) we could therefore decide to save even more. If the latter effect is powerful, then low interest won’t have the hoped-for stimulative effect.
In this sense, the Bank’s belief that guidance is necessary reflects a grim view of the economy – a belief that companies have lost the desire to invest and that households have been over-borrowed.
There might, though, be another reason why rates could stay low, even if these thoughts are wrong and the economy does recover. It’s that low interest rates on cash are good news for a government worrying about the cost of its debt. One reason for this is that, because cash is a substitute for government bonds, low returns on cash imply high prices for bonds and hence a lower cost of servicing debt. And if they do eventually lead to inflation, this would erode the real value of nominal debt. In this sense, persistent low rates serve a function which Carmen Reinhart of the Peterson Institute for International Economics calls “financial repression.”
Of course, it is not Dr Carney’s job to worry about debt service costs, so this should not be a motive behind his “guidance.” But sometimes there are happy coincidences in policy-making.
