What is the right interest rate for the U.K. economy?

What is the right interest rate for the U.K. economy? Economic commentary on this issue is almost entirely seen through the lens of whether the official Bank of England rate is currently too high, or too low. With exactly a month to go until the next decision from the Monetary Policy Committee the debate again centres on the wisdom of moving from its existing level of 5.25%. Whether the economy is best served over the coming couple of years from lower borrowing costs and lower savings rates – or a more aggressive fight against inflation – is seen as the key judgement. However these are arguments on incremental changes, rather than levels. Rarely does the financial news cycle provide the space to step back and ask what a sensible level is for UK interest rates. A level that both supports the need for price stability – namely low inflation – but also supports growth, a productive economy, and financial stability.

For most of the last fifteen years it has been widely assumed that the appropriate interest rate around the develop world, including the UK, was quite low. Between 2009 and the end of 2021 UK inflation averaged just 2.1% a year, whilst the official UK interest rate averaged less than 0.5%. Despite hundreds of billions of pounds worth of Quantitative Easing – the purchase of government debt by the Bank of England – the supply of broad money grew at a modest 4.5% per year. The UK unemployment rate over the period averaged less than 6%. This was not an economy whose headline indicators were screaming that the interest rate level was too low.

But over the same period productivity in the UK economy collapsed to a third of the rate it had been in prior decades, whilst wealth and income inequalities remained stable. This embedded the ramp up in differences seen during the 1980s and 1990s. Real wage growth and labour mobility – a key enabler of growth – both went into reverse.

Purists amongst the central bank community may argue that this dispiriting scorecard on other economic variables is an issue for fiscal policy – namely the tax system – not interest rates. Or even that other weapons in the central bank arsenal – such as mortgage market regulation – can address the fallout from an interest rate that had undesirable spillovers. This approach has a long lineage dating back to at least the late nineteenth century when the Swedish economist, Knut Wicksell, defined this natural rate of interest as one consistent with a stable growth in the price level.
What if that thinking is misplaced for the modern economy? What if the fact that interest rates get into all the cracks makes it a more influential economic force than just helping to control the price level? If the spillovers have been large and have contributed to a stagnant economy – and I think they have – a more developed debate is now required on the interest rate level deserves equal attention to its monthly change.

This would have been a very difficult debate to have prior to the recent bout of high inflation. Central banks would have argued that despite their stimulative stance, employment was growing, price growth was indeed stable, and the world economy was showing little evidence that it needed a higher cost of money. But the last three years have weakened that defence. Contrary to almost all economist expectations the world economy has absorbed – in almost every major nation bar Japan – a big move higher in interest rates and yet demand has not collapsed, unemployment has not spiked, deep recessions have largely been averted. At the very least this episode calls into question whether interest rates at their emergency setting for more than a decade were necessary, and negative spillovers could have been reduced.

There is uncomfortable dynamic right now where central banks are claiming credit for bringing inflation down from their peaks whilst claiming credit for their actions. Critics may argue – and I would be amongst this number – that the evidence that disinflationary impacts from interest rates (absent some housing weakness and a slight nudge higher in unemployment) is rather less pronounced than they appear keen to claim credit for. When the Governor of the Bank of England, Andrew Bailey, talks about “strong evidence” higher rates are working he may have a different definition for strong evidence than most. A less charitable argument can be made that supply chains adjusted to the Ukraine War-indued energy shock, and growth is now accelerating again.

One area where the impact of prolonged low interest rates was most apparent was in the decision of pension funds and insurance companies to buy large quantities of debt and reduce their traditional ownership of shares – creating a steady de-risking of their investment stance. This was rational at the time. Central banks were buying up large quantities of debt so there was a ready buyer to take these assets off investor hands – invariably at a higher price – down the line. This headwind to the most flexible form of financing – equity capital – contributed to a lack of innovation and growth. To me it is no surprise with interest rates remaining high that the FTSE 100 and Dow Jones share indices have made record highs this month. It tells me that the investors are seeing a greater attraction from equity with, I suspect, a positive blowback on the ability of companies to finance innovation and growth. A higher cost of money may also have wider beneficial effects in limiting the “hunt of yield” that has poured huge resources into zero-sum financial engineering such as we have seen at Thames Water, or in the surge of interest in cryptoassets.

This is of course not a uniquely U.K. phenomenon, the current US economic experiment with a huge federal budget deficit and an elevated interest rate is asking questions of the world economy. Is that combination a more appropriate policy stance or, as seems more likely, this is a privilege reserved for the world’s biggest economy – and a risky one at that.

But overall it would be right to ask, in light of recent events, whether the UK economy is simply more stable and more productive with a higher interest rate level than we became accustomed to after the Global Financial Crisis.

Published on The Times: 20/05/2024