Sunday, April 16, 2023
Don't expect a return to pre-Covid interest rates
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.

A debate has been running for the past few days which should be of intense interest to borrowers and savers, to anybody in business and to the financial markets. With the Bank of England contemplating whether it needs to take UK official rates to a new 14-year high next month, the question is whether we have said goodbye permanently to the near-zero rates that prevailed for well over a decade after the 2008-9 financial crisis.

It is a question I get asked a lot. People who have a year or so to go before re-fixing their mortgage want to know whether rates will be lower by then. The medium and long-term level of rates matters hugely for a wide range of business decisions. Savers who are finally getting something in return for their money (though still a significant negative real return) want to know by the Ither even this will be snatched away from them again.

The issue was raised by the International Monetary Fund in its latest World Economic Outlook and summarised in an IMF blog headlined “Interest rates likely to return to pre-pandemic levels when inflation is tamed”.

The blog, by two of the authors of the World Economic Outlook chapter, Jean-Marc Natal and Philip Barratt, notes that a range of factors, including demographics, have pushed interest rates down in recent decades.

As they put it: “Since the mid-1980s, real interest rates at all maturities and across most advanced economies have been steadily declining. Such long-run changes in real rates likely reflect a decline in the natural rate, which is the real interest rate that would keep inflation at target and the economy operating at full employment–neither expansionary nor contractionary.”

Students of economics will know that the natural rate has a long pedigree in economics and was applied to interest rates in the late 19th century and subsequently taken up by Keynes. The natural rate of unemployment is another familiar concept.

According to the IMF authors, the natural rate of interest for most advanced economies remains very low. And, in what looks like a very bold claim, they expect it to reassert itself quite soon.

“Overall, our analysis suggests that recent increases in real interest rates are likely to be temporary,” they write. “When inflation is brought back under control, advanced economies’ central banks are likely to ease monetary policy and bring real interest rates back towards pre-pandemic levels.”

There is a big ‘if’ there, which is the question of when inflation is brought back under control, which I shall return to. There are also a couple of caveats. So, if governments lost control of debt and deficits, this would push bond yields, and thus the natural rate across all maturities, higher. Related to this, funding the shift to a green economy through deficit financing could have a similar effect.

The central conclusion looks, however, to be clear. The inflation shock has pushed interest rates higher than is warranted and, as it subsides, they can be expected to come down again.

Does this mean a return to the long [period between March 2009 and May last year, when official interest rates in the UK never rose above 0.75 per cent? Is this just another way of saying what central banks did when they were initially very reluctant to raise interest rates in response to the post-pandemic rise in inflation, regarding it as temporary or “transitory”.

Inflation is now coming down, with America’s headline rate of consumer price inflation now down to 5 per cent, although with the core rate stickier. The peak in interest rates is certainly close if not already here.

Let me, however, take the IMF’s view and look at it in the context of UK interest rates. As we shall see it is more complicated than first appears. The analysis is couched in terms, not of actual interest rates, but real rates, those adjusted for inflation.

If we take the post-crisis period when Bank rate never rose above 0.75 per cent for more than 13 years (March 2009 to May 2022) consumer price inflation over that period averaged 2.3 per cent. Official interest rates were consistently below inflation, so real rates were negative, and some would say that contributed to the subsequent inflation. It certainly contributed to asset price inflation, including property.

Even now, after a succession of interest rate rises, Bank rate remains well below actual inflation of 10.4 per cent, though it is higher than where the Bank predicts inflation will be in a year’s time, 3 per cent in the first quarter of next year, falling to less than 1 per cent in the second. If these forecasts are anywhere near right, and the Bank turns out to be in no rush to cut rates, we may be moving into a situation of positive real rates, for the first time in a long time.

If nothing else, given both the long period of negative real rates and the scale of the current shock, which has badly shaken its reputation, you would expect the Bank to want to run with a period of positive real rates for some time to come.

There is, too, another issue. Suppose the IMF is right and the natural real rate of interest for the UK is somewhere between zero and 0.5 per cent, which is far from implausible. The way that translates into actual interest rates over the medium and longer term depends on where inflation settles.

If, after the steep fall generated by recent big energy price increases dropping out of the comparisons, inflation was to settle at 2 per cent, the official target, then that would imply a level of Bank rate higher than after the crisis but lower than now; between 2 and 2.5 per cent.

It is not preordained, however, that inflation will settle at 2 per cent, even though that is the average for UK consumer price inflation over the past 25 years or so. For, if we take the period from Bank independence in May 1997 to the eve of the pandemic at the end of 2019, it was very much a tale of two inflation rates.

Goods price inflation over that period was very low, averaging just 0.9 per cent a year. Service sector inflation, however, perhaps a better guide to domestically generated inflation, averaged 3.4 per cent a year.

History could repeat itself but that seems unlikely. The China effect, a key element of globalisation, held down good prices but is fading as a factor now. Negligible increases in goods prices are less likely in the future than they were in the past.

This has two potential implications. Either inflation settles at between 3 and 4 per cent and adding even a modest real rate to that means that Bank rate in the medium and long-term is not much below current levels. Or, in the effort to get down from that 3 to 4 per cent to the 2 per cent target, the Bank is required to operate with higher real rates.

Either way, we have moved decisively away from the near zero rates that were the norm in the pre-pandemic period, and we should not expect a return to them. And, while that may be painful for some, it is no bad thing.