Monetary Policy: Cheap but not Easy
It’s a rare day when an article in the Bank of England’s Quarterly Bulletin gets much press pick-up, but today’s article on how households would cope with higher interest rates is just such an occasion.
The article basically argues that households would cope surprisingly well if interest rates were to increase by 2%. Interestingly this is based on an annual survey that the Bank conducts and the data hasn’t changed radically since 2013. What has changed is the emphasis and tone of the Bank’s analysis.
This has been interpreted by some as a covert, or not so covert, signal from the Bank that rates may soon be set to rise.
That seems unlikely for a couple of reasons. First, because the analysis suggests that households would cope well with rates up 2% if their nominal incomes rose by 10%. And that isn’t expected to be the case in the short term. And second because if the Monetary Policy Committee (MPC)did want to signal quicker rate rises, then there are easier ways to do that than an article in the Quarterly Bulletin.
I took the QB article as basically being in line with the existing argument from the MPC — when rate rises do come they will be gradual and the ‘end point’ will be lower than before the crisis.
As the Bank has been a great pains to explain, their long run average interest rate was been around 5% but in the next few years we should expect something closer to 2.5% to be the ‘new normal’.
Stepping back for a moment though, I do think this sort of analysis tells us something interesting.
In recent years there’s been a great deal of talk about the lower bound of interest rates — the point(conventionally taken to be zero) below which they can’t be cut further.
But it’s worth taking a moment to ask — what’s the upper bound for interest rates?
As the hedge fund manager Hugh Hendry noted a few weeks ago:
“…you can define the upper bound to today’s interest rates by trying to determine society’s capability to meet those interest payments at higher and higher levels.”
With household debt — and indeed debt in general — set to be higher, that upper bound for the UK has fallen over time.
The Bank hasn’t plucked that 2.5% level out of thin air and there’s a reason why they now argue that we shouldn’t expect 5% anytime soon. Until that debt burden is either paid down or incomes rise strongly enough to reduce the debt/income ratio — then low rates are here to stay.
Macroeconomically that all makes sense. But the worry is that extended period of low rates may encourage the sort of risk taking that can endanger financial stability.
“The highly abnormal is becoming uncomfortably normal. Central banks and markets have been pushing benchmark sovereign yields to extraordinary lows — unimaginable just a few years back. Three-year government bond yields are well below zero in Germany, around zero in Japan and below 1 per cent in the United States. Moreover, estimates of term premia are pointing south again, with some evolving firmly in negative territory. And as all this is happening, global growth — in inflation-adjusted terms — is close to historical averages. There is something vaguely troubling when the unthinkable becomes routine.”
Accepting that rates are going to remain low though doesn’t necessarily mean signing up for repeated bouts of financial instability. The circle can (perhaps) be squared by the new kid on the block: macroprudential regulation.
This is the new (and in the world of central banking) exciting tool kit which allows central banks try and mitigate the risk of financial crisis by varying things like loan-to-income ratios and capital requirements.
In a perfect world the combination of effective monetary policy and effective macroprudential policy would allow central banks to both have their cake and eat it. To keep interest rates low to support the economy whilst tweaking access to credit to prevent dangerous bubbles.
Of course it might not work, we don’t yet have a long experience of how macroprudential tools will play out on a large scale in practice.
But if I was betting on likely path of UK monetary policy in the next few years, I’d assume headline rates were going to remain historically low (even if not quite on the floor) but macroprudential interventions would increase.
In effect we’d have cheap money but not necessarily easy credit. Or at least that’s the theory.
