Tuesday, 13 August 2013

Same low interest rates but for longer

The central bank in the UK pledges to keep interest rates low for years to come but that still might not be enough to achieve the desired result.

The current slump in the global economy is proving frustrating for economists who had come to think of themselves as bastions of sound economic management.  Tried and tested policy tools such as changing the level of interest rates have only had a limited effect, as have new ideas such as quantitative easing (for more, see Why is the economy still in a rut?).  Mark Carney set out to begin his stint as the new governor of the central bank in the UK with a bold fresh approach to monetary policy but his timid initial parley seems to be a rehash of existing measures.  The new stance taken by the Bank of England aims at making low interest rates more attractive but it does not seem as if anyone is interested.

The not-so-new policy concept announced by the British central bank was that of forward guidance which entails providing greater clarity in the future direction of interest rates.  This is expected to improve the intended effects of interest rates which are set by the central bank depending on the state of the economy.  The Bank of England has set its base interest rate (which determines most other interest rates in the economy) at 0.5% since May 2009 but what is different with forward guidance is that Carney has stated that the base interest rate will stay at this level until the unemployment rate falls from 7.8% to 7.0% which is not expected to happen until the middle of 2016. 

In other words, the Bank of England is promising three more years of record low interest rates.  But this pledge comes with a big caveat – the central bank may raise interest rates if inflation looks set to stay above 2.5% over the medium term (economists are a bit neurotic about inflation – for reasons why, see Time to rethink Inflation?).  So Carney has tried to provide as much clarity as possible on the future of interest rates while leaving himself leeway to change interest rates earlier if necessary.  The Bank of England already gave some guidance on interest rates but linking the interest rates with unemployment makes this more explicit.  A similar policy framework has been tried elsewhere – most notably in the United States where the Federal Reserve has also committed to low interest rates until the job market improves.  But it is as yet unclear whether the forward guidance has had any notable effects.

The theory behind low interest rates and forward guidance is as follows – low interest rates when the economy is on a weak path are intended to entice firms and consumers into borrowing more and spend this extra cash to help make up for any shortfall in demand.  But this has not worked out so far as lending by British banks has been falling since the global financial crisis.  Guidance whereby low interest rates are pledged for an extended period of time is meant to fix the aversion against taking on debt by easing concerns that any borrowing now will be penalized with higher interest rates once the economy picks up – thus adding to any impetus to take out a loan.  But Your Neighbourhood Economist does not hold much hope for forward guidance to add much punch.

For forward guidance to work, economists are relying on a piece of theory known as rational expectations.  This assumption is that companies and consumers respond not only to current prices (including interest rates) in an economy but also expectations of these prices in the future.  Since low interest rates have not had the intended effect, economists have seemingly come to the conclusion that it is because of worries that the low interest rates will not last.  And so the hope is that by alleviating these concerns with forward guidance this will spark the borrowing that is meant to spur the economy into life. 

But to Your Neighbourhood Economist, it seems like trying to tempt shark attack victims back into the water by convincing them that the water is shallow.  This is because lots of companies went bust in the aftermath of the global financial crisis due to having borrowed too much.  Consumers too are still overburdened with excessive debt no amount of low interest rates ever seems destined to fix at this point in time.  The notion of rational expectations does not match up with what could be deemed as irrational fears of debt – hopes for borrowing our way back to economic growth seem too scary for most.


  1. Interesting how BOE interest prediction has consistently undershot since the crisis began. Why would anyone believe a prediction of 'hold steady', and there are even get-outs if the BOE gets it wrong - risking nothing makes it useless as a predictive tool 'trust us we are bankers', previous form would discount such promises and could prove counter productive in short order when seen as the warning flag that it is (we are out of ammo) by the markets. The real game has been to inflate away (increasing) government debt at the expense of deposit savers on the street amongst others - with its moral hazard implications, delayed retirement and blighted seed-corn youth. Economics really is not predictive or science, and guessing how the inflation genie cuts itself out of the gordian knot might as well be called the game of 'forward guidance' as something else. The end result will be real enough and no doubt unpleasant.

    1. It is still unclear to what extent central banks will allow inflation to take hold. I have written about the possibilities of countries inflating their way out of debt.


      But at the same time, economists are paranoid about inflation so it will be interesting to see whether they have a change of heart.

    2. Don't you think it's a bit odd Carney has moved his "trigger" from inflation to unemployment?

    3. I do not think that it is odd because the Federal Reserve in the United States already links its policy decisions to unemployment. Inflation is not much of a concern at the moment so it makes sense to adapt policy to reflect the feeble state of the economy. Data on unemployment is also a better indicator of the strength of the economy whereas inflation figures can jump around a lot. This is important with regard to the "new" policy of forward guidance - the link with unemployment gives a better sense of how long interest rates will remain at their current level.

  2. You didn't point out that this problem is exacerbated by the quantity of money in circulation consisting almost entirely of debt. The creation of monetary units, and the creation of credit denominated in that unit, should not be the same thing. We now appear to accept it as normal that it is, yet it is from this that the dilemma manifests.

    It has not always been this way.

  3. Sorry for my tardy reply. This is a good point. Normal banks can have a large impact on the money supply - more loans increases the money supply as loans typically exceed deposits of cash which are regulated by the central bank. This also explains why central banks have had to work so hard (through buying lots of bonds) to increase the money supply as banks have been reducing their loans and thus working in the opposite direction to what central banks are trying to do.