Sunday, July 06, 2003
Just how low can base rates go?
Posted by David Smith at 06:52 AM
Category: David Smith's other articles

When Mervyn King joined the Bank of England as a non-executive director in 1990, interest rates in Britain were 15% and there was a serious risk that they would go higher.

Now he has taken over as governor, interest rates are 3.75% - a quarter of their 1990 level - and there is a serious chance that they will go lower. Indeed, King's own hints last week were taken by the markets as pointing that way.

Had anybody seriously suggested in 1990 that we were facing a future with interest rates in low single figures he would have been thought of as dangerously eccentric. The average base rate for the previous decade was 12%. Excursions into single figures were rare and into low single figures unheard of. But that is where we are, and talk of a 3% rate is by no means fanciful.

King, who last week signalled his intention of becoming the "people's governor" by taking the Bank's message around the country, became chief economist in 1991 and deputy governor in 1998. It is tempting to attribute today's low interest rates to the efforts of him and his colleagues.

While I bow to nobody in my admiration for Bank independence, and its superiority to every framework for monetary policy that preceded it, it is clear we are witnessing a global phenomenon.

Indeed, the only similarity between now and a decade or so ago is that then interest rates in Britain were the highest among leading economies. They still are, but at a significantly lower level; Britain's base rate is 3.75% compared with the European Central Bank's 2%, the American Federal Reserve's 1% and Bank of Japan's 0%.

Interest rates are at their lowest levels for half a century, and even this does not tell the full story. In the 1950s, interest rates were only one of many weapons for controlling the growth of money and credit. In Britain, there were direct controls on bank lending and hire purchase. Mortgage lending depended on how much the building societies could raise from savers. Capital controls restricted the movement of funds between countries. Today's "control-free" environment makes the low level of rates even more remarkable. How much lower can they go?

Two weeks ago I looked at how the Japanese economy had come to be locked into economic stagnation and deflation - falling prices - and concluded that monetary policy makers had been too slow to spot a dangerous bubble developing in the late 1980s, and too slow to react when it burst.

Some would say the first part of that criticism equally applies to Alan Greenspan at the Fed a decade later. But he and his colleagues were quick to react when the stock-market bubble burst, and have carried on reacting, most recently with last month's cut in the Fed funds rate to just 1%.

Equally, though, the Fed, and for that matter the ECB and the Bank, might have expected the cuts so far would produce more growth than we have seen. The cuts by the Fed, from a rate of 6.5% to 1%, would, according to its own economic model, normally produce strong growth - well above 3% a year - and a big stock-market bounce.

In Britain, the Treasury's simulations showed that cutting interest rates to European levels would significantly boost growth and inflation - one reason it said no to euro entry. Yet rates have halved from their peak level of 7.5% since Bank independence, without a boom. Growth in the first quarter, 0.1%, was the weakest for 10 years.

The Bank for International Settlements (BIS), the Basle-based central bankers' club, noted in its annual report last week that "the global economy lost steam in the course of last year despite significant policy stimulus".

It added that there were unusual features about the current cycle and cited developments in the "geopolitical, economic and financial spheres" that had held back growth. That's a little opaque, even for a Swiss-based organisation. Decoded, it means the worries over global terrorism and Iraq, together with strains on the banking system, have prevented interest-rate cuts from being as effective as they should have been.

This leaves two possibilities. The first is that it is only a matter of time before economies explode into life under the impact of these interest-rate cuts, together with the fiscal stimulus - tax cuts and public spending - many countries are applying. This is what has hit the bond markets hard in the past few days. American policymakers, in particular, are leaving no stone unturned in their determination to ensure George Bush enjoys the pre-election boom denied to his father.

Here, Gordon Brown is going about it rather differently - putting up taxes. These are, however, producing a public-spending boom that may not be transforming services but is contributing to growth and jobs.

On this view, the problem is essentially one of lags. Monetary policy is the most powerful economic weapon known to man. In cutting interest rates aggressively, central bankers have lit the blue touchpaper and retired a safe distance. All they have to do is wait for the fireworks and hope there isn't a downpour. By later this year, and certainly by next, we should see a return to strong growth, in Britain and the world.

The second possibility is more worrying. On this view, central banks are doomed to continue cutting interest rates only to find that their action is ineffective. As in Japan, the once-powerful interest-rate weapon loses its force. The world economy, far from bouncing back, finds itself becalmed in an economic version of the Sargasso Sea.

This was the essence of the BIS's warning. World growth is sufficiently weak and unbalanced, with Europe and Japan continuing to underperform, to make deflation a serious risk. The apparent rejection last week of further rate cuts by Wim Duisenberg, the ECB president, looks odd in this context. "The difficulty at the present juncture is that many of the prior conditions needed for deflation to
become a problem seem to be in place," the BIS said.

Its central view is that the world economy will not succumb to deflation, and that is mine too. But the dangers are bigger than they were. The stock-market recovery is a stop-start affair reflecting doubts about the strength of the global upturn.

The recovery evidence is mixed. Central bankers need to be on their guard, beginning with the Bank this week. A cut in rates may look like a luxury, but it could soon be a necessity.

PS: My request for ludicrous or unbelievable economic claims has
produced two strands of responses. One is that many readers do not believe the claims made for EU membership, let alone for joining the euro. The yearnings for a plain old free-trade area, rather than the full EU paraphernalia, go deep.

The second strand is problematical for the government. Alastair Campbell may be brandishing the simple sword of truth but the fact is the government is not believed, particularly on public services. It was always recognised in the Treasury that the period between the April tax hikes and a discernible improvement in public services was going to be difficult. So it is proving to be. Labour is suffering in the polls and, despite the record of recent years, is no longer seen as more economically competent than the Tories.

It would take a political earthquake for such doubts to result in Labour losing the next election but the problem will not go away. Most people believe that government claims about public services are based on fiddled figures. It is hard to believe that, whatever his personal circumstances, Alan Milburn would have quit as health secretary if the NHS was in better shape after its massive cash
injection.

The government says that, with the exception of transport, public services are improving across the board. Voters, accustomed to the spin, aren't prepared to believe it.

From The Sunday Times, July 6 2003

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