Monthly Archives: September 2015

On Central Bank Interest Rates Panic (UK Edition)

The Bank of England (BoE) pays 0.5% interest to commercial banks on their deposits and it has remained that way for a long time now.

During this period quantitative easing (QE) has been used by the BoE. It does this by purchasing open-market gilts from existing holders of previously issued gilts – pension funds, insurance companies, high net worth individuals, etc, – who sell them indirectly to the BoE via banks, since the BoE doesn’t deal directly with other kinds of institution. This increased demand for ‘second hand’ gilts is what increases their price on the open market thus reducing the amount of interest they pay (since the original interest amount paid is fixed at the ‘coupon’ the government put on them when it initially sold them, so that as the price of gilts goes up or down on the open market the actual market interest rate relatively decreases or increases). The money the BoE pays the banks for these gilts then goes back into to the accounts of the people or organisations who sold them back to the BoE via said banks. Less the banking commission charged.

All this is done in an attempt to stimulate the economy by getting the gilts-sellers to do other stuff with their money. There has been similar behaviour from the US Federal Reserve (Fed) where interest rates have been set at 0.25% for a long time.

‘Normally’ it wouldn’t be necessary to do such a convoluted thing as QE because the economy could be stimulated through monetary policy by simply lowering a central bank’s interest rate to encourage spending, borrowing and investing. But you can’t do that when the official interest rate is already so low – at or near what is called the ‘zero lower bound’ (ZLB).

But in more ‘normal’ times there are actually two ways an economy can be stimulated – one is via central bank ‘monetary easing’ (reducing interest rates) – while the other is via government ‘fiscal policy’ (the government puts more money into the economy by lowering taxes and/or spending more itself). If the government can’t or won’t do it via its fiscal policy then the central bank has to try to do it via its ‘monetary policy’. This is the current situation because the UK government considers it essential to be as frugal as possible in its spending. As do governments in the USA and Europe. The answer to this conundrum since the Great Recession has been the ‘unconventional’ policy of QE. The Jury is said to be out about how well this has actually worked.

Now the UK economy has officially ‘recovered’, for whatever reason, albeit in a somewhat fragile manner: with GDP per head hardly at all, low levels of corporate investment, appalling level of business productivity, poor balance of payment figures – but, on the upside, with significantly lower unemployment figures and real wage/salary increases helped by an exceptionally low inflation level.  Therefore there has been increasing pressure on the BoE to start raising interest rates again in order to regain ‘normal’ levels of interest. The pressure of late has been somewhat noisy.

But the rationale for returning to ‘normal’ bank rate now is not at all clear. There are irrational arguments (about the evils of ‘printing money’, ‘unnatural interest rates’ etc) and some apparently rational arguments for increasing rates. One potentially rational argument for increasing the central bank rate is that continuing to stimulate an economy which is already growing under its own steam risks inflation. Another argument is that if the economy does tank again (China? House price bubble bursting?) then, at the ZLB, there will be no room for monetary easing to stimulate. Though the government cold still use fiscal policy to do so. However government action via borrowing (issuing fresh gilts) or otherwise printing money would be politically very difficult because of the emphasis the government, press and even the Labour opposition have been putting on eliminating the deficit. This would therefore be considered the mother of all U-Turns, causing the government to lose credibility.

However there is a funny thing about the inflation argument. It is generally agreed that there is a desirable amount of inflation to have. The official target set by governments in most advanced countries is 2%. In the UK the Governor of the BoE, who is charged with keeping inflation at that government-set level, has traditionally been required to write a letter of explanation to the Chancellor of The Exchequer for any up or down divergence from that level. But for quite a while now inflation has been below 2%.  Indeed, ‘core inflation’ (that is, excluding more volatile goods like oil and food, normally included in the official inflation measure) is currently only 1%, while the main official inflation figure (CPI) is about 0%. There is, therefore, some significant risk of deflation, not of inflation.

As far as the wriggle-room argument is concerned – that is all very well, but if you fear the economy may to go back into recession, the last thing you want to do is raise interest rates, thus possibly precipitating what you fear.

One further argument sometimes used for increasing rates now is that the official inflation figure (CPI) is misleading as it takes no account of the cost of housing. For the UK, while CPI is currently near 0%, an unofficial measure (proposed) which does take housing into account is CPIH, which gives a current annual figure for inflation of 0.3% (ONS to March 2015). So this argument is poor because even if we do try to take housing costs into account (in terms of average weighted ‘rental’ costs – which includes estimates based on cost of housing as well as actual rents) we still have very, very low inflation. A home is an asset which most people purchase relatively rarely, and some not at all – so raw house-price inflation cannot be included in the inflation figures.

It is a wide-spread assumption that ‘printing-money-causes-inflation’. It is clear that it can do so (Weimar, Zimbabwe) if an economy is already working to capacity and the money just goes to increase wages instead of producing more investment and goods. But it can be seen that over the last 6 years or so there has been very little inflation and the bigger risk now is that of deflation. The risk is worse because once deflation takes hold things can get very fraught. Deflation leads to a downward spiral of lower and lower spending by ordinary people and lower investment by companies: why buy now when the prices will be lower next month/year? Hence demand slackens and this feeds back again into lower spending and lower investment. This can even lead to complete economic collapse (as in Bruning’s Germany, after Weimar, which brought Hitler to power).

It is now well-understood by most advanced economy governments how to control inflation: usually just take the heat out of the economy by central banks increasing interest rates, which may go very high indeed if the inflationary problem looks like getting serious. But it is not at all well understood how to control deflation. As the Japanese may currently testify. And most especially if increased government spending is ruled out. Traditionally this problem is finally solved by governmental fiscal policy of investing and stimulating production via A-Good-War. Not so Good. Russia is probably spending a fortune on armaments. China?

So, given the small upside risk of keeping interest rates very low (excessive inflation which can be controlled by a reversal of policy) but the dire downside risk of raising interest rates prematurely: crashing the economy and increasing the deflationary spiral (need for a Good War), why are some people – meaning the press, bankers, retired people and allied pressure groups – demanding that the BoE must increase interest rates now?

The answer is easy to see as far as the banks are concerned. They make their money largely by the spread between what they have to pay for it and what they can get by lending it out. And this spread is very squeezed when official interest rates are near zero. So banks (read bank executives) are definitely losing out.  And woe betide a bank economist who breaks ranks. Obviously people who depend on the interest on their savings to live are also losing out, most especially the very wealthy who perceive themselves to be losing big as they just don’t know where to put their money to get a good return. As well, unfortunately, as pensioners. Property may seem like a good bet. But as its price goes up it gets more and more difficult to rent it out at a level which gives a ‘decent’ return. So the buy-to-let bubble, at least, may certainly burst.

You do not have to be much of a conspiracy theorist to believe that the press and many politicians are on the side of wealthy bankers, property investors and (good-heartedly… why not, if it suits?) pensioners.

You also do not have to be much of a conspiracy theorist to work out that a less than well-hidden motive for deficit reduction at-all-costs and as-quickly-as-possible is less a matter of economics than an ideological desire to ‘shrink the state’. Ultimately to the short-to-medium term benefit of the most wealthy via concomitantly reduced taxation. Unfortunately this has, indeed become what has been termed ‘deficit fetishism’. Deficit-Reduction and The-Debt-Must-Be-Reduced now-now-now have become memes with a life of their own.

Hence the pressure on the BoE to increase interest rates as soon as possible despite the fact that the official government-set remit of central banks is to maintain inflation at the level of 2%, which it is nowhere near, by any measure, while, anyway, inflation is quite easy to control by increasing interest rates if and when it occurs. And despite the fact that to increase the bank rate prematurely does risk tanking a still fragile recovery and bringing on full-bloodied deflation.

As it happens many economists have argued that 2% is too low an inflation level to set because, as has recently been well-demonstrated, it leaves little room to bring rates down before hitting the ZLB. The consensus among these economists is that 4% might be a more sensible target.


In its latest Global Financial Stability Report the IMF has warned that a global rise in central bank interest rates now would risk a series of defaults and a financial crisis in emerging markets as debts of non-financial firms in emerging market economies quadrupled, from $4tn (£2.6tn) in 2004 to well over $18tn in 2014. Thus liquidity in financial markets could dry up again, as Andy Haldane – Chief Economist at the BoE – has also warned.

Thus, we are again entitled to ask, as with the severe austerity policies of heterodox macroeconomics (but the so-called ‘conventional’ and ‘commonsense’ economics of the ‘right thinking’ mainstream political and business class) – Cui bono? – to whose benefit?

And now (mid Jan 2016) does not look good for the US Federal Reserve after it very recently raised its rate against much of academic macroeconomist advice. Ho Hum

And here we go again.

But at lease the cry for the BoE to increase interest rates seems to have quietened somewhat of late…

Not at all surprising, really when we view the situation the US Fed now finds itself in, as viewed by  Ryan Avent of The Economist