Danger of be­com­ing addicted to low in­ter­est rates

The Pak Banker - - OPINION - Andrew Sen­tance

THIS month, we passed the sev­enth an­niver­sary of the­Mon­e­tary Pol­icy Com­mit­tee's de­ci­sion to re­duce the of­fi­cial Bank Rate to 0.5pc, the lowest level in UK mone­tary his­tory. Be­cause the EU Ref­er­en­dum and the Bud­get have been dom­i­nat­ing the eco­nomic and fi­nan­cial head­lines, this an­niver­sary passed al­most un­no­ticed. How­ever, we have not seen a pe­riod of such pro­longed low in­ter­est rates here in the UK since the 1930s and 1940s. Then, the Bank of Eng­land's of­fi­cial in­ter­est rate was held at 2pc from 1932 un­til 1951 - ini­tially to re­spond to the prob­lems of the Great De­pres­sion and sub­se­quently be­cause of the im­pact of the Sec­ond World War. Apart from the 1930s and 1940s, I can­not find any pe­riod since the Bank was founded in 1694 when in­ter­est rates have been held at 2pc or be­low for as long as the last seven years. So we are liv­ing in very un­usual times for mone­tary pol­icy.

I was a mem­ber of the MPC when we cut in­ter­est rates to 0.5pc in March 2009 and em­barked on the pol­icy of Quan­ti­ta­tive Eas­ing. It was the right thing to do at that time be­cause of the deep­en­ing fi­nan­cial cri­sis and the need to pro­vide a boost to con­sumer and busi­ness con­fi­dence.

But the UK and the world econ­omy have moved on a long way since then. We are now in the sev­enth year of eco­nomic re­cov­ery. UK un­em­ploy­ment has been fall­ing fairly con­sis­tently for more than four years and the job­less rate is now be­low its pre-cri­sis level. The Bri­tish econ­omy has been ei­ther first or sec- ond in the G7 league ta­ble since 2013 and is likely to oc­cupy one of the top two slots this year as well.

So why are we stuck at a level of in­ter­est rates which was set to re­spond to an eco­nomic and fi­nan­cial emer­gency in 2009? The usual an­swer to this ques­tion is that there is no im­me­di­ate need to raise in­ter­est rates. We are in a low in­ter­est rate en­vi­ron­ment world­wide - not just in the UK - and there are many un­cer­tain­ties af­fect­ing the global eco­nomic outlook. In ad­di­tion, in­fla­tion re­mains sub­dued, par­tic­u­larly since the re­cent falls in the oil price.

How­ever, this line of think­ing does not take into ac­count the po­ten­tial prob­lems which a pro­longed pe­riod of very low in­ter­est rates may be creat­ing for the econ­omy at the same time.

There are four key neg­a­tive con­se­quences for the econ­omy which should be con­cern­ing cen­tral banks around the world.

First, the re­turns avail­able to savers have been de­pressed for many years now, while in­fla­tion has con­tin­ued to erode the value of sav­ings. De­spite be­ing very low re­cently, av­er­age in­fla­tion since in­ter­est rates were cut to 0.5pc has been over 2pc. A situation where real (ie in­fla­tion-ad­justed) in­ter­est rates are neg­a­tive means the value of sav­ings is be­ing eroded over time, not in­creas­ing. This of­fers poor in­cen­tives to in­di­vid­u­als to save for the fu­ture and makes it in­creas­ingly dif­fi­cult for peo­ple to pro­vide an ad­e­quate in­come in re­tire­ment. While a tem­po­rary pe­riod of low in­ter­est rates can be tol­er­ated by savers, if this per­sists for many years it risks un­der­min­ing the no­tion that sav­ing is a worth­while and pro­duc­tive ac­tiv­ity.

Sec­ond, low in­ter­est rates en­cour­age con­sumers to take on more debt - pre­cisely the prob­lem which cre­ated the dif­fi­cul­ties that led to the fi­nan­cial cri­sis in the first place. Un­se­cured lend­ing - such as over­drafts, bank loans and credit card debt - is al­ready grow­ing at about 6pc, ac­cord­ing to the lat­est fig­ures. The Bri­tish Bankers' As­so­ci­a­tion said last week: "House­holds are in­creas­ingly tak­ing ad­van­tage of low in­ter­est rates by tak­ing on more un­se­cured bor­row­ing." Mort­gage bor­row­ing has also been pick­ing over the past two to three years.

Third, house prices are be­ing pushed up - par­tic­u­larly in Lon­don and the South East - by the avail­abil­ity of cheap money. Of­fi­cial fig­ures last week showed that UK prop­erty prices were nearly 8pc higher than a year ago. The av­er­age UK house price is now worth nearly £300,000. While peo­ple who are al­ready home­own­ers con­tinue to ben­e­fit from low in­ter­est rates, high house price in­fla­tion pe­nalises younger peo­ple try­ing to get on the first rungs of the hous­ing lad­der - the so-called "Gen­er­a­tion Rent".

Fourth, the longer we con­tinue at the cur­rent level of in­ter­est rates, the more likely it is that busi­nesses and in­di­vid­u­als treat this as the nor­mal state of af­fairs. That makes it harder for the Bank or other cen­tral banks to wean the econ­omy off the mone­tary medicine and es­tab­lish a level of in­ter­est rates which is in line with or higher than in­fla­tion. The longer this pe­riod of very low bor­row­ing costs con­tin­ues, the greater the risk we de­velop an econ­omy addicted to ex­tremely low in­ter­est rates, in which even a small rise in rates is seen as a big shock to the sys­tem.

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