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Interest rates: myths, prejudices and politics

6 November 2015

Two adjacent articles in today’s Times are headlined “House prices forecast to rise by 20% over next five years” and “Rates will be on hold until 2017, says Bank”. The BBC reports that Dame Minouche Shafik, deputy governor of the Bank of England, nevertheless thinks that interest rates are “not the tool for the housing market”. The rest of us will wonder whether this is really joined-up thinking, and will wonder if her boss, Mark Carney, has any clear idea of how to lead us through the mess we remain in, eight years after the banking crash. (At least he had the understanding that his remit extended to commenting on the threats to the economy posed by climate change, rather that dismissing that as someone else’s job.)

The multiplicity of views of leading economists, all with access to infinite statistical data, simply reinforce the stock views about this profoundly incompetent discipline. What must by now be obvious is that support can be found for any course of action, and that the choice recommended by economists is a political one, dictated in most cases by gut instincts if not tribal loyalties.

So here (without bothering with the numbers) are some of my instinctive feelings about interest rates.

Firstly, the rates we have seen over the last eight years are indeed incredibly low. As the wilderness expands this point should not be lost on a generation of young savers who may never have known “normality”. But, whether you agree with Piketty’s forecasts, the historical data he analyses are indisputable. And I can add my own recollections from the 1980s when we were constructing tax deferral products and had to assume risk-free reinvestment rates for up to 15 years (which for technical reasons couldn’t be hedged): almost all of us thought that 10% was a minimum.

Second, both bank rate and the QE programme are artificial interventions that distort the operation of the free market. That in my view is a generally bad thing, unless the market is causing serious problems which demand intervention. The case for that is unclear.

Thirdly, the Chancellor’s continuing reckless enthusiasm for supporting house prices through programmes like help to buy and increased IHT-free bands is contributing to the distortion fuelled by artificially low interest rates, and the impact of reversing prices would be so politically damaging that we can assume this madness will continue.

Fourth: by keeping interest rates artificially low, borrowers benefit and savers suffer. The total amounts roughly balance, although the numbers of individuals may not be equal. But the savers will vote Tory anyway, while the young and feckless are more likely to swing and be influenced by a (false) sense of well-being. That is why this policy is more political than you might think.

Fifth: those who borrow to buy homes (by far the largest group) don’t actually benefit in cash, since house prices go up to compensate. And while at first sight you might say that home owners (many of them savers) are getting a compensating benefit, that is only on paper. Unless you sell up, you won’t have money in your pocket. And it is that which is needed to fuel growth in the economy by encouraging consumer spending. Older home owners with savings have far more discretionary cash which in normal times they are willing to spend: it is their fear, brought about by low rates, their memories of normality (they are older) and their concerns for a future which even the Governor of the Bank of England can’t predict from one week to the next, that is largely responsible for the sluggish economy.

Sixth: if you think that low rates spur investment, think again. Any industrial company is going to look for returns on capital from any investment project that are far higher than current interest rates. Reducing interest rates below about 5% will rarely have any impact on their spending plans. There are very few investment projects that are going to be attractive at 0.5% base rate which wouldn’t also be undertaken at 1%: the hurdle rate for decisions in most companies are much higher. (Remember too that small and medium sized businesses pay much more than the bank rate for their borrowings: the banks take a margin which used to be a small part of the return, but is now larger than the cost of funds.)

That is partly because businesses investing long term are also frightened about the outlook for interest rates, and don’t believe they will stay this low indefinitely. Or that Carney’s assurances have any value any more.

But it is also because we have an economy in which capital-intensive manufacturing has all but disappeared. Most surviving businesses – service industries – need far less capital than traditional ones, and there is some degree to which that may have set a new “norm” for interest rates. It is however impossible to establish that given the continued distortions represented by current government policies.

The one industry which has a seemingly undimmed need for capital is finance. We know that the banks remain undercapitalised. And readers of this blog will realise that the balance sheet figures will not take account of the true levels of leverage hidden in derivative positions and other financial engineering, and that there has never been a proper analysis of the combined profitability of the industry now so dominated by interbank trading. But it is not difficult to see that a great deal of the benefit of lower Bank rate has flowed into the banking sector, and much remains trapped in the pockets of employees. This was all justified by “trickle down”: but my guess is that many of these employees have not spent all their bonuses on consumer goods that would revive the economy, but rather have spent it on houses.

Which is where we started.

Postscript

One slightly confusing area about low interest rates is the effect on Government revenues from lost tax on savings income. In the OBR March budget ready reckoner, Table B1 reveals the Government’s model suggests that a 1% change in interest rates will result in a £1 1/4 billion impact. But a recent estimate for household deposit accounts (only a small part of total savings, and a falling one in view of the recent environment) is £1340 billion, 1% of which is £13.4 billion. Some (a disproportionate amount) of this will be held by higher rate taxpayers, so you’d expect the true impact to be far higher than the Government assumes – even without taking account of the likely switch back to deposits from higher rates. I wonder if the Chancellor understands this.

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