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Rates damage

A rise in interest rates might hurt the economy's long-term growth rate
May 1, 2018

Despite last week’s news of weak GDP growth in the first quarter it’s possible that the Bank of England will raise Bank rate next week.

Its reason for even considering such a move is that it believes that the economy’s potential growth rate is low, which means that even very moderate actual growth will create capacity shortages and hence inflation. “Demand growth is still expected to exceed the diminished rate of supply growth,” said Bank governor Mark Carney in February. “Domestic inflationary pressures are likely to firm as the economy moves from excess supply into excess demand.”

This might be mistaken. It’s difficult to estimate potential supply and, as Benoit Coeure, a member of the ECB’s executive board said last week, such estimates can themselves be excessively cyclical: they rise too much in booms and fall too much after weak growth.

There is, however, another question here: might a rate rise actually exacerbate the problem of weak potential growth?

Certainly, this has been a concern in the past. In the 1980s, economists feared that high interest rates, in throwing people out of work, led to a permanent loss of skills and hence to high inflation even at high rates of unemployment because unemployed workers were not bidding down wages: this was the hysteresis theory.

Such a view has been revived recently, however, by Mr Coeure and Oxford University’s Simon Wren-Lewis. Let’s suppose (reasonably) that new technologies are embedded in expensive new equipment. Then if companies expect demand to be weak, they’ll not invest in such technologies for fear they won’t cover their costs. We’ll then see an 'innovation gap' – a failure to take advantage of new inventions. The upshot will be continued low productivity as companies use outmoded kit. In this way, insofar as higher interest rates lead to depressed expectations of demand (not to mention higher costs of capital) they will also depress productivity. They will therefore exacerbate the problem Mr Carney is worried about – weak supply potential.

Mr Carney’s own words might add to the problem. If businessmen believe his talk of low potential growth, their motive to invest will be further diminished.

One big historical fact supports such concerns. It’s that, as Geoff Tily at Prime Economics points out, productivity growth was strongest in the 1945-71 period when macroeconomic policy ensured high demand, and it has faltered since then as policy stopped ensuring full employment.

Plausible as this mechanism is, there is also a countervailing one. It’s possible that higher interest rates might raise productivity if they force 'zombie companies' out of business, thereby freeing up labour and capital for more efficient companies. There is some evidence for this. Jan Willem van den End and Marco Hoeberichts, two economists at the Dutch National Bank, estimate that sustained periods of low interest rates have led to lower expectations for trend growth. 

If all this sounds inconclusive, it should. Economists used to believe that trend growth and cyclical fluctuations were two separate things and that monetary policy only affected the latter. This, however, might not be true: monetary policy (and expectations of it) might have longer-lasting effects than merely cyclical ones. Doubts about whether this is the case are one reason why the Bank of England should – and probably will – raise interest rates only very gradually.