Monday, 14 July 2014

Question – Interest rates

In response to an inquiry from a reader, Your Neighbourhood Economist explains how low interest rates should have but didn’t affect the economy (with a surprising culprit)

Your Neighbourhood Economist was pleasantly surprised to have a proverbial knock at the door (a photo of which was posted on the blog recently along with an email address for questions) with the following inquiry on interest rates…

I read your blog entry on BOE interest rate hike and needed an opinion. I'm not a finance student but am trying to understanding why something so unusual is happening with the BOE interest rate. You have explained why there is a need to hold the rate low at the moment, seeing there isn't enough inflation yet (as posted in UK Interest Rates – putting off the inevitable). But could you explain to me in layman's terms how this has affected our economy and what other solutions could have been used?

Interest rates are a hot topic at the moment with changes afoot at the Bank of England.  Sometime over the next six to twelve months, the UK central bank is likely to raise its benchmark interest rate off its record low of 0.5% where it has been for more than 5 years.  Low interest rates are the most common way that central banks will try to raise economic growth.  The theory behind this is that cheaper loans will push businesses and households into borrowing money and this extra spending will boost the economy. 

Good in theory but not in practice

In practice, things have not worked out so well.  Businesses have held off taking out loans due to uncertainty over the future direction of the economy.  Companies need to be assured of a decent return from any investment which will typically only make money over the span of several years.  Worries about the future earning potential of any new operations have outweighed the lower costs of borrowing money to invest.   As a result, business lending in the UK has fallen for seven consecutive years with companies preferring to hoard cash instead. 

The main benefactor of low interest rates has been the property market.  House prices in London held up despite the global financial crisis and added to the myth that property values never fall.  So once the worst of the crisis was over, low mortgage rates prompted many to scramble to buy property.  The buoyant housing market has boosted the economy a bit by making people who own property feel richer and spend more.  But more mortgages only pushes up house prices rather than making the economy more productive as investment by businesses would have done.

So the actual effect from low interest rates has been less than hoped.  This resulted in central banks also using quantitative easing – creating new money to buy bonds and other financial assets.  The aim of quantitative easing is increase the amount of money in the economy and help out the banking sector.   Quantitative easing too has been somewhat of a disappointment with few places for the extra cash to be put to good use.  The banking sector typically acts as one of the main means to move cash around the economy but banks have had to focus on their own survival.  The surplus of cash has created its own problems such as distortions in the financial markets which may cause trouble in the future.

Other solutions…?

With businesses not spending and mortgages not adding much to the economy, the obvious solution would be for government to make up the shortfall.  A fiscal stimulus is the typical response to a slowdown in the economy with the extra spending by government making up for weak demand from consumers and businesses.  Yet, government finances in the UK and elsewhere were already stretched before the crisis and deteriorated further with higher welfare payments and falling tax revenues following the crisis.

The Eurozone crisis from 2010 resulted in investors shunning any countries with high levels of government debt.  This prompted the UK government to launch its austerity program with the hope convincing investors that it would sort out its finances.  The plan worked in that the interest rates on UK government debt remained low (also with help from quantitative easing) unlike some countries in Europe such as Ireland and Spain.  However, cuts to government spending hurt the economy and prolong the slump in the economy while also ironically making even more cutbacks necessary.

Still struggling

Getting ourselves out of trouble following the global financial crisis was always going to be tough going.  Recessions stemming from banking crises are typically longer than normal recessions as it takes time to work down the excessive levels of debt and fix the banks.  Less expected was how the economic recovery has been further hampered by ineffective and lacklustre policies. 

Fiscal policy has been working in reverse and the UK government should do more to boost the economy considering that investors are no longer so worried about government debt.  The Bank of England could have done more with monetary policy considering that it can print as much money as it likes but it held back due to misplaced concerns about inflation.  Your Neighbourhood Economist would have liked to have seen more spending by the government and quantitative easing going straight into the economy.

Perhaps the biggest factor holding back the recovery is that economists are slow learners.  Policies such as quantitative easing are new and have helped but more could have been done if economists had not been so caught up with their own ideas.  It is of some consolidation that lessons from the Great Depression (such as the bank bailouts) have been applied to ensure that a similar type of crises has resulted in less fallout.  We can only hope that this crisis is bad enough to ensure better policy in the future.  

(Please add any further questions on this topic using the comments section at the bottom of the page or email any inquiries on different issues related to the economy to


  1. Thank you so much for this well explained answer! Any deductions on what would happen if they increase the rates in that time frame? Would this reduce uncertainty in businesses? What about inflation?

    1. It is not clear what effect an increase in interest rates will have. I argued about that low interest rates had little effect so slightly higher interest rates will probably not substantially change much. However, the potential impact on the hearts and minds of consumers and investors is hard to gauge and an interest rates hike may dampen the fledgling economic recovery. Uncertainty for businesses will continue and may even get worse. Inflation is also likely to remain subdued until the global economy takes off which does not seem likely. Inflation these days tends to depend more on global commodity prices as wages in the UK (which is the other major cost for business) has been stagnating for decades.

      Hope this extra bit of explanation helps.

  2. Thanks a ton!