Welcome to the upside-down world of interest rates; a world where little is as it seems, where what looms large can be unimportant, where what’s important often remains unnoticed, where low can really mean high and vice versa. Not that there should be anything terribly strange about this because, with interest rates, so much of the time this is how it is; it applied to 2017 and may apply to 2018, too.
Chiefly, it’s an upside-down world because the factors that are supposed to drive interest rates – the ones that get the attention from the talking heads who spout about ‘quantitative easing’, the ‘equilibrium real rate’ or ‘utility functions’ – are not so significant in the long run.
The present provides a neat example. Last month, after much huffing and puffing, the Bank of England’s Monetary Policy Committee – the technocrats who set the central bank’s core interest rate – finally raised bank rate. In fact, they doubled it at a stroke; although, given that the new rate – 0.5 per cent – was still only back to the level it had been from 2009 to 2016, doubling it hardly counted as ‘shocking’. In explaining its decision, the committee ran through the familiar reasons – the pace of UK inflation, the unemployment rate, the slack in the economy’s capacity and so on. These provided a plausible argument for raising rates.
However, the point is that in the long run the influence on the course of interest rates of these – and similar – macroeconomic factors is like a mud bank against a flood tide. Bigger forces control interest rates; or – to fine-tune that – big forces, then still bigger ones. It’s when we come to look at those that we see that the world really is upside-down. But let’s start with the easy bit: why did the central bank raise UK rates?
There is no need to look further than the Bank of England’s latest inflation report, released just after bank rate was doubled to 0.5 per cent. The bank lists four key judgements that it believes are sufficient to justify the rise:
■ Global economic growth is set to remain firm. The bank reckons that global output will grow by 3.75 per cent in 2018, slightly higher than it estimated earlier in 2017. True, that’s below the 4 per cent average for the years 1997-2007, but that was an exceptional phase buoyed by China’s astounding performance. Projections for China’s sustainable growth rate are now down to 6 per cent. Meanwhile, global output will be helped by recovery in the euro area and continuing steady growth in the US. But throughout the developed world – and especially in the US – rising demand will start to knock against capacity constraints, which is likely to force prices up.
■ The UK’s output will be supported by some revival in capital spending and a boost to exports provided by a combination of decent global demand and the weaker pound. Against that, pressure on household incomes could restrain consumer spending.
■ Little slack remains in the UK’s output capacity, so even modest growth may stoke inflation. The UK’s unemployment rate, which peaked at over 8 per cent in 2011, is now down to 4.3 per cent, its lowest in 42 years. So expansion of supply, which would constrain inflation, depends heavily on better productivity. Yet the UK’s productivity – output per hour worked – has not budged for the past 10 years compared with average improvements of over 2 per cent a year before then. That could change, but substantial capital spending – both from the public and the private sector – would be needed to achieve it and the benefits would not work through for some years. Meanwhile, the economy’s efficiency is likely to be compromised by the Brexit process as companies re-arrange production and supply lines and quite likely cut capital spending while uncertainty is at its worst.
■ Domestic pressures are likely to keep UK inflation above the bank’s target of 2 per cent for some time. As Chart 1 shows, the inflation rate is already well above that target. The bank thinks the rate will have peaked at about 3.25 per cent late in 2017, but is still likely to be above 2 per cent in three years’ time. That would be a function of sterling’s continued weakness, the growing propensity of companies to pass on their higher input costs and the related inclination of employees to press for higher wage settlements as their own expectations of future inflation are re-calibrated upwards.
So, after a fashion, UK interest rates are on the rise and both the central bank and other forecasters expect them to go further in the coming years. But savers probably won’t benefit. While long-term interest rates have been rising since the UK’s electorate voted to leave the EU in June 2016 (Chart 2), rates for cash individual savings accounts (Isas) are at rock bottom and they have not even stirred following the increase in bank rate (Chart 3). That’s partly because rates will remain at nominal levels – the Bank of England expects its bank rate to be no more than 1 per cent by 2020 – and partly due to the absence of keen competition between high-street banks.
But there are bigger, darker forces at work against which even central banks struggle. These forces have been depressing ‘real’ interest rates for 30 years and they can be lumped under three headings – ‘savings glut’, ‘peak savings’ and ‘secular stagnation’. The key to understanding the first two is demographics. As people go through middle age, their income generally rises, as does their propensity to save as they contemplate retirement. And it just so happens that, owing to the post-Second World War baby boom, from the late 1980s onwards the developed world had an unprecedentedly large cohort of affluent middle-aged folk with an urge to save. This phenomenon began depressing ‘real’ interest rates – ie, rates with the inflationary component deducted – from the late 1980s even though nominal interest rates often seemed quite high.
Following this trend – and reinforcing it – came a similar imperative to save among the new middle classes of the developing world, especially in China. There, the absence of a comprehensive welfare system, the effects of China’s one-child policy, and government measures that favoured saving over consumption worked to create huge current-account surpluses, which were channelled into the safest havens, mostly US government Treasury bonds. Taken together, the effect of this savings glut – also helped by oil producers recycling their export surpluses – was to depress the developed world’s real interest rates. This occurred even while the hustle and bustle of lively economic activity – plus plenty of speculation on the side – should have forced rates higher.
At some point, however, the inclination to save must pass its peak. Demographic forces drive this, too. People retire and turn their savings into income. Then, theory suggests, when saving turns to spending, capital will become scarcer and the balancing point between supply and demand will settle at a higher interest rate.
Maybe. As the world’s ‘oldest’ nation, Japan could offer a clue. For some years its working-age population has been shrinking as a proportion of the whole. From peaking at 70 per cent in the mid 1990s, the working-age cohort has slipped to 60 per cent on its way to a still-smaller fraction. This has clearly affected Japan’s inclination to save. Household saving as a proportion of income has been declining since the late 1980s and is now a mere 1 per cent. As yet, however, this trend shows no sign of pushing Japan’s interest rates higher. Japan’s economy remains shrouded in a funk where it is growing at about 1.5 per cent a year; its inflation rate barely bobs above zero and its nominal interest rates are even lower.
The explanation may be that Japan is in an advanced state of secular stagnation, where unfavourable demographics combine with the absence of technological innovation to lock nations into low growth, leading to limited demand for capital thus keeping interest rates low, both in nominal and real terms.
It is too soon to say whether this condition afflicts the rest of the developed world, although it’s tempting to suspect so. Yet it may not even be relevant because, on another view, there are still bigger forces that drive interest rates and, from this perspective, today’s low rates are not that unusual at all.
Gertjan Vlieghe, an economist and member of the Bank of England’s monetary policy committee, outlined this notion in September when he told the Society of Business Economists that “interest rates right now are not at ‘emergency levels’ or ‘unprecedented levels’. We are currently in a low interest-rate regime. Many find it disconcerting that it is so different from the high interest-rate regime of the 1980s, but that regime was itself in many ways more unusual than the current regime”.
Mr Vlieghe’s core point is that real interest rates depend not on the likely growth rate of an economy, but on how risky the economy is and whether the risks and rewards are skewed towards the favourable or the painful side.
Adopting a very long-term perspective, he suggests that during the gold standard eras of the 19th and early 20th centuries business cycles were short and regular, inflation was volatile but zero on average and real interest rates were high. He suggests that the widespread adoption of fiat money, where money supply is controlled by governments or central banks, and the development of a sophisticated finance industry in the second half of the 20th century changed all that – “increased debt and a larger financial sector brings the economy closer to an efficient allocation of resources, but also makes the economy more vulnerable to shocks. Higher leverage and a larger financial intermediation sector mean that a downturn can become amplified”.
In such risky circumstances risk-averse consumers are willing to pay more for low-risk savings whose nominal return is safe pretty well come what may. In other words, they accept lower real interest rates, especially when economic mayhem breaks loose and, one way or another, levels of leverage – debt to equity or to income – have to fall.
Mr Vlieghe reckons that levels of leverage, which were dangerously high as 2008’s financial meltdown showed, may now be close to acceptable levels; or at least that consumers and companies have repaired their balance sheets as much as they want to. In which case, the current nudge-up in interest rates may be logical.
Whether it will match the ultra long-term swings in risk is another consideration, though – on one level – that may not even matter. Last month, Mr Vlieghe’s colleague at the Bank of England, Ben Broadbent, the deputy governor in charge of monetary policy, told a gathering at the London School of Economics that “to adapt the football manager’s cliché, we can only play the economy that’s in front of us. What’s been in front of us for several months is an economy with above-target inflation and dwindling spare capacity”. True, that’s the response of the pragmatic money manager rather than one who seeks the profound causes. But in 2018 neither approach is likely to bring savers much benefit. Interest rates will rise, but not so you’d notice on the high street.
