The dangers of prolonged low interest rates

• Tweet
• Pin It

The Centre for Economics and Business Research believes that the UK economy has double-dipped back into recession. To pile on the misery, it predicts bank rate will remain at 0.5% until 2016, which would make a total of eight years. Not only this, but it expects the Bank of England to increase its programme of Quantitative Easing from £275 billion to £400 billion this year. This is appalling news for savers, who currently lose £44.5 billion through the gap between inflation and average interest rates.

Not everybody agrees that the Bank of England has got it right, however. We pointed out Anthony Hilton’s article in the Evening Standard which asked whether it was time to think about raising rates. Last week’s minutes of the Shadow MPC revealed that Andrew Lilico of Europe Economics, a former supporter of the Bank’s policy, has changed his mind.

“Current official policy appears to be to try to keep households clinging on, through maintaining policy interest rates at approximately zero, even if that comes at the expense of inflation and significant further deterioration in the value of the pound… It cannot be right to maintain such a policy for more than an emergency period… How long is it morally defensible to protect those that over-indulged and that made mistakes at the expense of those that were more prudent and restrained? A policy that can be perfectly correct if implemented over a year or two years might be the wrong policy if it must be repeated for ten years… There should be a rapid normalisation in interest rates – perhaps to 3.5% over a four- or five- month period.”

The Bank of International Settlements warns of the dangers

The prestigious Bank of International Settlements, the Central Bankers’ bank, also sees dangers in maintaining low interest rates. As we pointed out recently, the BIS reckoned the Bank of England had exaggerated the positive effects of QE. The Annual Reports of the BIS also question low interest rate policies. In June 2010, a section was headed: “Low interest rates: do the risks outweigh the rewards?”

“Policymakers need to consider the distortions caused by prolonged conditions of monetary ease. After all, sustained low interest rates have been identified by many as an important factor that contributed to the crisis… Previous episodes of low interest rates suggest that loose monetary policy can be associated with credit booms, asset price increases, a decline in risk spreads and a search for yield. Together, these caused severe misallocations of resources in the years before the crisis, as evidenced by the excessive growth of the financial industry and the construction sector. The necessary structural adjustments are painful and will take time.”

It points out the need to clean up the balance sheets of financial institutions, households and the public sector and worries that:

“Low policy rates may slow down or even hinder such necessary balance sheet adjustments… (and) may diminish the sense of urgency for reducing leverage and selling or writing down bad assets. Central banks’ commitment to keep policy rates low for extended periods, while useful in stabilising market expectations, may contribute to such complacency.”

It warns that low policy rates allow “evergreening”, with banks extending unviable loans, even if only the interest is being paid, to preserve their own capital. Zombie firms so supported limit competition, reduce investment and prevent the setting-up of new companies. It is also concerned about the public sector.

“By shifting their debt profile towards shorter-term financing, governments can reduce interest rate payments. While this provides them with useful breathing space for returning sovereign debt levels to a sustainable path, it also exposes fiscal positions to any increase in policy rates if the needed budgetary adjustments are not put in place in a timely manner. This can raise concerns about the independence of monetary policymakers.”

It concludes:

“Keeping interest rates very low comes at a cost – a cost that is growing with time. Experience teaches us that prolonged periods of unusually low rates cloud assessments of financial risks, induce a search for yield and delay balance sheet adjustments.”

The Bank of England risks sowing the seeds of the next crisis

Last year’s BIS Annual Report reiterated the message:

“The persistence of very low interest rates in major advanced economies delays the necessary balance sheet adjustments of households and financial institutions. And it is magnifying the risk that the distortions that arose ahead of the crisis will return. If we are to build a stable future, our attempts to cushion the blow from the last crisis must not sow the seeds of the next one.

“Governments that put off addressing their fiscal problems run a risk of being punished both suddenly and harshly. And if that day comes, experience teaches us that the fiscal consolidation measures needed to regain the confidence of investors will be substantially larger, more difficult and more painful than they would have been… The prolonged period of very low interest rates entails the risk of creating serious financial distortions, misallocations of resources and delay in the necessary deleveraging in those advanced countries most affected by the crisis.”

The report does not look in detail at savings but a BIS working paper pointed out that “sharply lower interest rates imply a transfer from creditors to debtors which could result, over time, in a reduction in saving propensities and in the prospects for longer-term growth.”

In other words, by keeping base rates at a negligible level the Bank is harming the country’s future growth prospects. The example of Japan’s great economic stagnation, where bank rate was cut to 0.5% in 1995 after an asset price bubble, should serve as a salutary example. Today, their rate languishes at 0.1%.

And, in another example of just how extraordinary things have become, the Chancellor is currently trying to drum up investment in Asia. Having gone back on his opposition promises to help Britain’s savers, he is now clearly hoping for help from Chinese savers.

• Tweet
• Pin It

One Comment

1. frances

   January 20, 2012 at 9:28 am

   George Osbourne and David Cameron have both gone back on their promises to help savers
   Clearly they think all savers are idiots and ripe to have their pockets picked in order to subsidise all those who would not know prudence if they fell over it
   DEBT rules in the UK
   Prudence is fleeced
   The poor are taxed for the priveledge
   What a truly disgraceful situation and Mervyn King and the MPC are complicit in the theft while they all sit pretty on £250K a year plus

   Recommend (11)