How much will interest rates rise in the next few years? Bank of England governor Mark Carney gave us a way of thinking about this question last week when he discussed the equilibrium interest rate.
This, also known as r*, is the interest rate that would keep inflation around its 2 per cent target and keep the economy growing steadily.
We know that this rate is now low. If it were high, then low actual rates would have led to a boom in investment spending and demand and to sharp rises in inflation. That we haven’t seen these tells us that r* is low; the MPC estimates it to be 2-3 per cent. Actual rates should gradually converge to this rate.
But what determines r*? Two broad things, according to the Bank.
One is desired wealth. The more of this we want at any given interest rate – and the less we want to borrow – the lower will r* be. This is because a given rate will be accompanied by high saving and low borrowing.
The other is the desired capital stock. If companies want to have a big capital stock at a given interest rate, r* will be high. This is because they will borrow a lot.
The Bank believes both these forces have depressed r*. An ageing population means higher desired saving and less desired borrowing as we anticipate our retirement. And the desired capital stock is low because of low expected future growth.
Here, however, savers have some hope. Maybe r* will rise.
One way it might do so would be if or when uncertainty fades. Uncertainty about Brexit has depressed companies’ investment. If or when this uncertainty is resolved, the desired capital stock might rise and with it r*. Also, over time the effect the 2008 crisis has had in depressing animal spirits should fade. That too should raise the desired capital stock and hence r*. And there should come a point at which companies will stop repairing their balance sheets and building up cash.
Secondly, it’s possible that the “fourth industrial revolution” won’t be mere hype. If robotisation, AI and other technical breakthroughs raise the desired capital stock they will raise r*. Even if this revolution happens overseas rather than here (the UK has so far had one of the lowest take-ups of industrial robots in the developed world) it will raise our interest rates. This is because rates are highly correlated across developed economies, so a rise in r* elsewhere should raise it here.
Thirdly, another wave of globalisation might raise r* by – in effect – bringing into the world economy millions more younger people who want to borrow. (China’s entry into the world economy had the opposite effect because it has high desired wealth and saving – but this won’t be true of Africans and south east Asians.)
Sadly, however, none of this guarantees us higher interest rates. For one thing, there’s an offsetting factor. It’s that while companies have repaired their balance sheets since 2008, households have not. In fact, the Office for National Statistics says that last year they spent more than they received in income for the first time in almost 30 years. If or when household incomes start to rise in real terms, some will respond by paying off debt. That will hold down r*.
Also, we cannot be at all sure what r* is. It “cannot be directly observed” says the MPC. Measures of it are “highly imprecise” says FOMC member John Williams. And its determination is, says M&G’s Eric Lonergan, “strikingly vague”.
Most economists' best guess is that interest rates will very gradually rise towards an r* or 2-3 per cent. And maybe r* itself will also rise over time. But these are only tentative guesses. Savers have, therefore, a glimmer of hope. But only a faint one.
