Sunday, May 07, 2017
Ultra-low rates made us lose our productivity mojo
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

There have been times in the past when voters were entitled to be nervous about interest rates in the run-up to a general election, because of the fear that nasty surprises would be on the way after polling day.

So, in the six months after Margaret Thatcher’s May 1979 victory, interest rates rose by no less than five percentage points (from 12% to 17%), while in the year after her 1983 victory they went up from 10% to 12%. In 1987, rates went up a couple of months after the election, though only briefly.

Before the May 1997 election the Bank, in the person of Eddie George, had been agitating for higher rates, without success. The task of raising them after the election initially fell to Gordon Brown – the last chancellor to raise rates – before being handed over to the newly independent Bank of England. There were six rate rises in the 12 months or so after May 1997.

It is fair to say that few are on tenterhooks this time. Under independence, the interest rate and electoral cycles have not been aligned. In 2001 the monetary policy committee (MPC) was cutting rates before the election and carried on afterwards. In 2005 the MPC held off a rate cut until after polling day. The 2010 election was held with Bank rate at a then record low of 0.5% and it stayed there for the whole five years of the following parliament.

Not only that, but the Bank has shown little inclination to budge from its new record low for official interest rates of 0.25%. It will put flesh on the bone of its intentions with an interest rate decision and new inflation report in one of its periodic “super” Thursdays this week.

But, while one MPC member, Kristin Forbes, has voted for a hike in rates and another, Michael Saunders, recently set out the arguments for doing so, it would be a big surprise if a rate hike happened this week or, indeed, if the Bank signalled its intention of moving on rates in the coming months. Forbes has one more MPC meeting after this one before she steps down.

The markets do not expect a rate hike until 2019 – the 10th anniversary of the move to ultra low interest rates – and some have not given up on the idea of a further rate cut, even from 0.25%, if the economic going gets tougher.

There may be some adjustment around the edges – economists at Goldman Sachs think the Bank may move shortly by tightening what they describe as credit easing; reversing the cut in the so-called counter cyclical buffer made in the wake of the Brexit vote – but the big picture looks to be an unchanging one.

A year ago it was possible to look forward to small and gradual increases in interest rates, but the Bank has responded to Brexit, and will continue to be influenced by its fallout. We will get a new forecast from the Bank this week, which may nudge down this year’s growth forecast, but, comparing its February predictions with those made in May last year, before the vote, it expects the economy in 2019 to be roughly 2% smaller than it did then, and the price level about 2% higher.

The first quarter gross domestic product numbers, released in late-April and showing quarterly growth of just 0.3%, will have reinforced the case from most MPC members for keeping rates on hold. Though April’s purchasing managers’ surveys point to a rebound, the Bank will wait for further evidence on that.

It is easy to forget, given how long we have lived with ultra-low interest rates, how extraordinary they are. A 0.25% Bank rate is mind-bogglingly low but even it does not tell the full story. It ahs been accompanied by unconventional measures, most notably £435bn of quantitative easing (QE). QE was undertaken to provide an additional monetary stimulus to the economy at a time when it was thought impossible to cut interest rates further.

Neil Williams, chief economist at Hermes Investment Management, has applied the rules of thumb offered by the Bank on what its QE programme was equivalent to in terms of interest rate cuts; £200bn of QE is equivalent to 1.5 percentage points off Bank rate, the Bank estimated in 2009. And, because the Bank regards the stock of QE as the key measure, £435bn is equivalent to more than three percentage points off interest rates.

So the true rate of interest, adjusted for QE, is -3% - minus 3% to spell it out, Williams calculates. He thinks, in the absence of rate hikes, the Bank should restore some normality quietly running down QE. It could do this by not reinvesting the proceeds of the maturing gilts – UK government bonds – it has bought under the QE programme. But the Bank’s current policy, most recently set out in November 2015, has been to keep reinvesting those proceeds until Bank rate gets to 2%, which is a long time away. So the stock of purchased assets will be maintained, and the extraordinary looseness of monetary policy will persist.

It is easy to forget, too, that ultra-low interest rates have consequences. One of those consequences is very weak productivity. There are many reasons for the stagnation of productivity (output per hour or output per worker) of recent years. But the weakness of productivity coincides with the period of low rates, and it is not hard to see why.

One of the aims of monetary policy during and after the financial crisis, was to avoid the wave of bankruptcies and redundancies that the scale of the recession of 2008-9 and its aftermath implied. It was supplemented by pressure on banks and other lenders to show greater forbearance to firms in difficulty.

In this, it generally succeeded. On most measures, from corporate failures through unemployment to mortgage repossessions the crisis’s impact was much smaller than feared.

But this, as is also recognised, prevented the process of “creative destruction” that normally happens in a big recession, in which weak firms go to the wall and are replaced by new, higher-productivity businesses.

This effect is acknowledged within the Bank. Andy Haldane, its chief economist, estimated in a recent speech that had interest rates been kept higher – he gave a figure of 4.25% - there would have been a big increase in failures, but also higher productivity. He suggested productivity would have risen by about 2%, though at the cost of 1.5m jobs. He said he would prefer the jobs as, given the choice, would every politician.

I think the productivity effect of ultra-low rates may be bigger than this. They enable healthy firms to coast rather than undertaking productivity-enhancing investment. When businesses cease to expect significant or indeed any rate rises, there is no incentive to invest to take advantage of low rates.

Low rates , to stress again, are not the only reason for weak productivity. But the question, as the clock keeps ticking, is how long this can continue. The near-zero rates that were a logical response to the crisis, and helped the economy trade weak productivity for more jobs, have taken on an air of permanence. So too, unfortunately, has stagnant productivity growth.