Massive public spending and a shrinking workforce could limit future rate reductions
Threadneedle Street has slashed interest rates by five percentage points in just one year, following the financial crisis.
Many experts thought that the cost of borrowing would permanently be lower. This belief is still widely held. The Bank of England, the International Monetary Fund and other economists still believe that rates will return to pre-crisis lows after this bout of inflation. As the fight to cool down the economy drags on, the voices of discontent are becoming louder.
Megan Greene warned earlier this week that ultra-low interest rates are not guaranteed. She warned that it would be a “mistake for central banks to think that inflation and rates are going to automatically return to the low levels before the pandemic.”
Who is right has a huge impact on the economy.
The cost of borrowing would be higher for governments who are already bloated from debts after the pandemic. Servicing mortgages would also become more expensive.
According to the Office for Budget Responsibility, a percentage point increase in borrowing rates can wipe out £20bn per year of Treasury spending power.
In order to put things in perspective, Chancellor Jeremy Hunt only left himself a slender fiscal buffer of £6.5bn (£6.5m) by 2028.
The Federal Reserve has begun to raise its expectations for where borrowing costs are likely to settle over the long term, barring major shocks.
All of these factors are dependent on the level at which central banks can set their interest rates, without stoking demand or restricting it.
Charles Goodhart is a former member the Bank of England’s Monetary Policy Committee who is one of the prominent economists that argue this level is rising.
He says that the main factors driving up interest rates and prices are the growing protectionism in US-China tensions, and shrinking labor forces due to population ageing.
He believes that interest rates in the future will be around 4.5pc. This is only slightly lower than the current 5pc level, which is the highest level since the financial crisis .
He says that “if you want to know the future, then you must understand the past.”
Since the 1990s, interest rates have been steadily falling until Covid.
Many economists think that the ageing population has fueled a rise in retirement savings and slowed productivity gains.
Andrew Bailey, Governor of the Bank of England , made this argument back in March.
The amount of money that households who deposit their savings in banks effectively lend to them will be much higher.
As a result, the remuneration (interest savings) will fall.
Goodhart, whose interpretations of the past are different from Bailey’s argument, believes that the ratio between workers and inactive people is going to fall. Some economists point out that older people are more likely to spend their income on services because they don’t have mortgages.
Goodhart states that the last three decades, from 1990 to 2020, were exceptionally unusual in history.
He says that favorable geopolitical events such as the fall of the USSR and the rise of China, and the growing number of workers have led to “much smaller increases in wages and prices than would be normal”.
He adds, “Rather than continuing to follow the same pattern of the past 30 years, the labour market will be tighter and more difficult.”
He says that other trends, such as the massive investment needed to fund the net zero transition , will also increase inflationary pressures.
After the Russian invasion of Ukraine, the Government has decided to increase defence spending by £11bn in five years.
Ministers are also under pressure to reveal a British response the US $369bn Inflation Reduction Act (£290bn), and the EU Green Deal, both of which funnel vast amounts into net zero transition.
Labour has recently reversed its plans to borrow £28bn a year for the same purposes due to rising borrowing costs.
Kallum Pickering of Berenberg says: “We green our economies much quicker than the relative prices of green technology would be if the market were left to its devices and therefore, this inflationary.”
Pickering believes that the Bank of England base rate will settle around 3pc-4pc over the long term, which is well above the 15-year average.
Interest rates are affected by technological advances such as the rapid growth of artificial intelligence.
Pickering says that technological development can have a disinflationary effect on the sectors it impacts. “But, if these technological advancements are significant enough to improve living standards in a meaningful way, one finds that the confidence factor adds more to the demand than the technology does to the supply.
“Therefore it is strange that industrial revolutions have in the past tended to be inflationary, rather than deflationary.”
BNP Paribas analysts recently warned that, while they believe interest rates will continue to trend down over the next decades due to higher retirement savings levels, they are more likely to rise in the near future.
The surprising resilience of the UK, US and Eurozone economies in the face of rising rates may indicate that the level of interest rates that neither limit nor stimulate demand has shifted upwards.
They said: “It suggests that there is limited room for rate reductions without providing an excessive stimulus to the economic system, increasing the risk of inflation reaccelerating once central banks remove the brakes.”
In that regard, the report would confirm our long-held belief that it may be difficult to bring inflation back to 2pc.
The majority of economists still believe that interest rates will be high for a long time.
If they’re right, it could pose a serious problem.
“We already have very high debt levels and they will continue to rise.” Goodhart says that this is a fiscal issue which has not been addressed at all.