14 September 2017
Low interest rates – a blip or the new normal?
When economic heavyweights disagree.
by Frank O’Nomics.
In a week in which UK inflation exceeded expectations, coming out at 2.9%, getting within a whisker of the point at which the Governor of the Bank of England and the Chancellor have to exchange letters, it might seem strange to discuss the prospect of interest rates staying low forever. However, even if rates were to rise early next year (and most economists surveyed recently still do not expect a move until 2019) any move is expected to be very modest, particularly during the Brexit negotiations.
If one assumes that most start work in the City at the age of 21, then no trader under the age of 31 has worked in the market at a time of a UK rate rise and, by 2019, there may be a limited number of traders left who are comfortable managing the consequences. Many argue that low interest rates are here to stay, and are largely the consequence of living in a mature society with an ageing population. However, new research, by Charles Goodhart and Manoj Pradhan, argues the opposite. They suggest that an ageing population will ultimately lead to higher inflation and hence higher interest rates becoming the norm. It will ultimately be very important to decide which side of this debate we should side with, both in terms of our own investment and borrowing profile, but also in the manner in which central bankers manage our economy.
In the blue corner we have the likes of Ken Rogoff from Harvard. Professor Rogoff, with Carmine Reinhardt, produced one of the key books of the financial crisis, This Time Is Different, and he is now asserting that central bankers need to start preparing for negative interest rates – yes, we will have to pay to hold money in a bank account. Such a tool will be needed in the next recession he argues, due to a lack of evidence to suggest that quantitative easing or forward guidance have “shown an ability to overcome the problems posed by the zero bound”. Negative rates could work much better he suggests and the impact will be much more immediate given the decline in the inclination to hold physical cash. Previously it had been assumed that, trying to impose negative interest rates on personal bank accounts would just not work – people would just take their cash out of the bank and stuff it under their mattress, rather than be forced to invest it. However, the rapid decline in the use of physical cash, and the preference for paying for goods and services electronically, direct from bank accounts, has begun to make the the prospect of a negative interest rate regime much more viable.
In the red corner sit Charles Goodhart and Manoj Pradhan. In research just released by the BIS they argue that a process of labour migration which has been going on over the past three decades is coming to an end. This ready and seemingly inexhaustible supply of cheap labour, much of it moving from Asia to the US, helped to keep prices low and hence interest rates on a declining path for a long period of time. While many argue that inflation and interest rates are a function of growth, and that an ageing population will inevitably lead to slower growth and lower rates, Goodhart and Pradhan suggest otherwise. First a declining availability of cheap labour will push up the cost of production. Second, the need for an elderly population to dissave during retirement will reduce the availability of cheap capital. The continued safety net provided by governments in form of a state pension and a health service, will mean that younger workers will remain less inclined to save, also limiting the availability of capital.
The obvious example with which to counter these arguments is the experience of Japan over the last three decades. A policy of low interest rates and almost limitless quantitative easing has yet to create any meaningful inflation, and the working population continues to shrink by around 1% each year. However, there is a risk that Japan is either an exception, or that inflation does ultimately pick-up even there.
Clearly, both sides of this debate may be proved right if we look at differing timescales. It is quite likely that a growing number of central banks will need to look at introducing negative interest rates over the next few years, vindicating the arguments of Professor Rogoff. However, it is the long term outlook that will be key and it is here that Goodhart and Pradhan may be proved right. If this is the case there is some cause for optimism. Low or negative inflation has very worrying consequences for the burden of both personal and national debt in real terms. We will need some price growth to help inflate away the problem. However, there is a real danger that central banks are reluctant to raise rates when they should, due to the high levels of debt that have been built up through the period of low rates. It is for this reason that Goodhart and Pradhan advocate a shift in policy measures from debt to equity finance. The numbers would suggest that, for many, such a move could already be too late.
If you enjoyed this article please share it using the buttons above.
Please click here if you would like a weekly email on publication of the ShawSheet
