Sunday, August 01, 2021
Low rates seem here to stay - thanks to older savers
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. Not to be reproduced without permission.

The Bank of England’s monetary policy committee (MPC) will on Thursday announce its latest decision on interest rates and it is fair to say that it would be regarded as an economic and financial earthquake if it was to vote for an increase from the current record low Bank rate of 0.1 per cent.

There is another interesting decision for the MPC to make, which is whether to proceed with the full amount of quantitative easing (QE) it agreed on last November, or whether to hold back on the final £50 billion.

Following recent comments by several of the nine members of the MPC, expectations are for a split vote, so it would be a much smaller surprise if the Bank decided to call a halt now, though the consensus view in the City is that the MPC will stick with the programme, in spite of above-target inflation and a strongly recovering economy.

We shall see. But, returning to interest rates, the monetary weapon that people most notice, you will recall that the official rate was reduced to 0.1 per cent, in two steps, in March last year as the pandemic hit. The pre-pandemic rate was 0.75 per cent, which also happened to be the highest since early March 2009.

You read that correctly. For more than 12 years, official interest rates have been below 1 per cent. For younger readers this will seem like the norm. Older readers, who recall interest rates well into double figures, including Bank rates of 16 and 17 per cent just four decades ago, may still be rubbing their eyes in disbelief.

There have been periods when Bank rate has been becalmed before, at 5 per cent between 1720 and 1821 and 2 per cent over 1932-50, though never at levels as low as now. In fact, until the financial crisis more than a decade ago, Bank rate which has been around since 1694 had never been below 2 per cent. The view at the time was that this was, in the jargon, its lower bound, because of the potential damage an even lower rate would inflict on the banking system.

Financial markets do not expect the current low interest rate regime to end soon. Economists at Deutsche Bank in London have just brought forward their expectation of the first post-pandemic rise in rates, but they do not expect it to happen until August next year, with an increase to the heady heights of 0.25 per cent.

Thereafter, Deutsche Bank expects two quarter-point hikes in February 2023 and May 2024, taking the rate to 0.75 per cent, which you will recall is the highest it has been since early 2009. That will mark the end of the tightening cycle, they say, with the rate then close to the “neutral” rate, with no need to hike more to keep inflation under control.

For those of us brought up in an era in which interest rates could go up by two percentage points or more in a single day, this kind of upward progress on interest rates seems painfully slow. Compared with the mountains of the past, a molehill is in prospect.

It is also painful for many older people. In the debate over honouring the triple lock on pensions, despite this year’s hugely distorted average earnings figures, many pensioners have contacted me to point out that low interest rates mean that they have lost out on most of the savings’ income they used to rely on.

Low interest rates benefit borrowers, who tend to be younger households. They hurt savers, who tend to be older. Low bond yields benefit the government, by reducing the debt interest bill, but also hurt pensioners, because they are linked to annuity rates.

To add insult to injury, perhaps, one member of the MPC, Gertjan Vlieghe, in his final speech as an external member of the committee, argued that the combination of an ageing population and the tendency of older people to keep their growing wealth in safe, or risk-free assets, is a significant factor bearing down on interest rates. This process began 30 years ago and, he argued, has further to run.

“We are only about two thirds of the way through a multi-decade demographic transition that is affecting interest rates,” he said. “Absent policy changes, there is no prospective reversal in this particular driver of interest rates: downward pressure from demographics either continues further or remains where it is.”

There has often over the years been a focus on household debt, but it is outweighed many times over by household wealth. At the latest official count, aggregate household wealth in Great Britain (so excluding Northern Ireland), net of borrowing, was £14.63 trillion, £6.1 trillion of which was in private pensions, £5.09 trillion in property wealth and £2.12 trillion in financial wealth.

Wealth is plainly not evenly distributed but it works out at more than £540,000 per household. It is skewed towards older households. And, as Vlieghe observed, the old life-cycle assumption that people build up wealth in the run-up to retirement and run it down when retired does not work, “the higher saving of the middle-aged outweighs the modest dissaving of the retirees”.

The wealth and savings of older households are not the only factor pushing down on the neutral rate of interest but they mean that current ultra-low rates are not just the consequence of a cautious MPC being unwilling to take a risk with rate hikes. The implication is that even if the Bank wanted to hike aggressively, it would soon find itself with interest rates above the levels necessary to hit the 2 per cent inflation target and maintain economic growth.

These things can never be set in stone. In the 1950s and 1960s, few would have thought that interest rates in double figures would soon become the norm. We will hear more from the Bank this week but it is set to confirm its view that the current inflation shock, which could push the consumer price measure up to 4 per cent later this year, is temporary.

Were that not to be the case, higher inflation became embedded, and the Bank was forced to raise interest rates more than it and the markets expect, that would open up a new dilemma. Every increase in interest rates would add to the government’s debt interest bill. An independent Bank, sitting on £895 billion of government bonds thanks to QE, assuming it sticks to the programme, could be responsible for adding tens of billions a year to that interest bill.

A new paper from the National Institute of Economic and Social Research, ‘Quantitative tightening: Protecting monetary policy from fiscal encroachment’, by its director Jagjit Chadha, together with Wiliam Allen and Philip Turner, addresses this issue.

As it points out: “The vulnerability of the central bank’s balance sheet (and thus government finances) to lower bond prices and higher policy interest rate is therefore now greater than at any time during the QE decade.” Some have suggested that, to limit the impact of higher interest rates, the Bank should stop paying the banks interest on their reserves at the Bank.

The paper proposes a different solution. It is somewhat technical but it should start, the authors say, with the Treasury swapping out some of the long-dated gilts (UK government bonds) it holds as a result of QE for shorter-dated paper. This process should start now, “to protect the independence of the central bank”.

Low interest rates and QE have changed the monetary landscape. Both can be changed and there is arguably more scope for running down the vast amounts of QE the Bank has undertaken than there is for raising interest rates too aggressively. The Bank has found itself in a position that those running it in the past could never have envisaged. Getting out of it will be a tricky task.