Sunday, December 06, 2015
Low long rates - for as far as the eye can see
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


My regular column is available to subscribers on This is an excerpt.

It is time for a confession. In my first piece this year, on January 4, while admitting that I was torn on the issue, I predicted a “token” quarter-point rise in Bank rate, to come late in the year.

To be fair to myself, it took me only about three weeks to decide that it was probably not going to happen, after inflation lurched downwards and the two “hawks” on the Bank of England’s monetary policy committee (MPC) withdrew their vote for a rate hike.

There was a brief flurry of excitement in the summer, when Mark Carney warned that a decision to raise rates would come into sharper focus around the turn of the year. But that came to nothing and, barring an enormous surprise this week when the MPC meets, this will be the sixth full year in which there has been no change in rates. The seventh anniversary of the cut to 0.5% comes in March.

The debate about whether or not the Bank should raise rates has been running for so long that most of the arguments are very familiar, though Jan Vlieghe, the MPC’s newest member, brought some fresh perspective when I interviewed him for last Sunday’s paper.

On the question of whether the Bank should follow the Federal Reserve’s likely rate hike later this month, his argument was that what the Fed’s move may tell us about the American economy has to be weighed against what the European Central Bank, which eased again on Thursday, is telling us about the eurozone.

Growth in Britain’s economy is pretty reasonable; expectations following the latest purchasing managers’ surveys are for a 0.6% fourth quarter rise in gross domestic product. But the economy is not racing away, and has slowed compared with last year. Above all, as foreshadowed at the start of the year, there is no inflation and oil prices dropped again last week.

All these are straightforward reasons why the MPC has not pushed the button on interest rates this year. But there is another factor, which is also weighing on the Bank’s decision-makers; the sustained downward pressure on long-term interest rates.

Bank research on it has been described in one of the Bank’s “Underground” blogs and featured in speeches by Carney and Andy Haldane, the Bank’s chief economist. It should be published as a working paper soon under the not so snappy title ‘Secular drivers of the global real interest rate’, by Lukasz Rachel and Thomas Smith. I should declare an interest; one of the authors is my son.

The traditional view of long-term interest rates – such as the interest the government pays on the bonds (gilts) it issues – is that they are determined by the outlook for short rates and the credibility, or creditworthiness, of the issuer.

The traditional view also is that you expect long-term “real” rates – the interest rate less expected inflation – to be positive. Investors do not lend to governments or other bond issuers for nothing; they expect a real return. Three decades ago, that real rate was around 5%

But not now. Though real rates have picked up a little with this year’s very low inflation, the trend has been firmly downwards; if not to zero (though they have been there) to something under 1%.

The Bank’s research looks in detail why this has happened and finds that most of it can be explained by a series of economic factors. It claims to identify why a fall in long-term real interest rates of 4 percentage points, or 400 basis points, is justified by these factors. 50 basis points of the total fall of 450 is unexplained.

The factors are demographics – principally the slowing of global population growth and ageing in advanced countries – which has reduced real rates by 90 basis points; higher inequality within countries, 45 points, and higher savings in the emerging world following the 1997-8 Asian crisis, 25 points.

Other factors include a drop in private investment, 50 points, and a reduced emphasis by governments on public investment, 20 points. Another technical factor is what the authors describe as an increase in the spread between the risk free rate and the return on capital, 70 points. On top of these, which together account for around 300 basis points of the drop in real rates, another 100 is explained by a worsening outlook for trend, or long run, growth in the world economy.

There is no need to get hung up on the precise numbers. The essential point is that long-term interest rates are not just low because central banks have been operating with near-zero short-term rates. They are low because of a range of factors bearing down on them, and most of those factors were in place well before the crisis.

And this is where it feeds back importantly to MPC thinking and the outlook for interest rates, if long-term interest rates are permanently low, there is a limit to how much, when the time comes, the committee can push up short rates. A 5% Bank rate would, for example, be inappropriate in the context of 10-year gilt yield of under 2%, as they are now, or even if they were to rise into the 2% - 3% range, but no more.

That is why those on the MPC who say they are in no rush to raise rates genuinely mean it. If it were a case of having to get rates up from 0.5% to 5%, they might be more impatient to get started. If it ends at 2%, they see time as on their side. It is also why, despite a lot of scepticism about such guidance, it seems reasonable to accept the Bank’s line that interest rates will peak at much lower levels than in the past. If the past seven years have been a nightmare for savers, the next few might not be much better.

Finally, that wait for the Bank to unwind its £375bn of quantitative easing will be a long one. We know now that it will not happen until Bank rate reaches 2%. Not so long ago that would have been a mere staging post for interest rates. Now it starts to look like the final destination.