Low Interest Rates: King Midas’ Golden Touch?

Kristin Forbes

External MPC Member

Bank of England

Institute of Economic Affairs, London

24 February 2015

King Midas’ Golden Touch

The Costs

The UK Economy Today

• UK recovery well in progress and self-sustaining– Still substantial challenges & scars from recession– But economy largely normalizing after severe & protracted crisis

• One exception: interest rates– Near-zero rates key part of crisis response & early stages of

recovery– Near-zero rates provide a number of benefits

• But there are also costs and risks

Potential Costs of Low Rates

(1) inflationary pressures;

(2) asset bubbles and financial vulnerabilities;

(3) limited tools to respond to future challenges;

(4) an inefficient allocation of resources / lower productivity;

(5) vulnerabilities in the structure of demand; and

(6) higher inequality

Key question today: Does the policy of near-zero interest rates risk going the way of Midas’ golden touch?

Risk 1: Inflationary Pressures

Recent and Forecast CPI Inflation

Source: BOE, February Inflation Report

Domestically-Generated Inflation (DGI) Measures

Source: ONS and Bank calculations.

1998 2001 2004 2007 2010 2013-4.0

-2.0

0.0

2.0

4.0

6.0

8.0YoY inflation %Range of DGI measures

DGI measures recently stable

Inflation: Looking Forward

• Low headline inflation and stable DGI unlikely to persist• Output gap closing• Wage inflation picking up• But pressures should build slowly

• Risks that inflation could pick up faster• See Jan. speech, “Risks Around the Forecast• Also risks that inflation picks up more slowly

• Bottom line: current policy does not yet appear to be generating incipient inflationary pressures that could not be addressed in a timely fashion as needed

Risk 2: Asset Bubbles & Financial Instability

Risks to Financial Stability

• Various risks:• “Search for yield” • Bubbles• Increased risk by banks• Increased debt issuance by companies• Long academic literature on risks (see speech text)

• Financial Policy Committee (FPC): 1st line of defence

• Will the tools of the FPC be enough in the future? • Risks magnified over time & by lower rates in other

economies•

• May be role for monetary policy to “get in the cracks” in the future, albeit not today

Risk 3: Limited Monetary Policy Tools in the Future

UK: Frequent Use of Bank Rate

Source: OECD and Bank of England.

UK business cycle slowdowns and Bank Rate:

UK: Bank Rate Adjustments During Slowdowns

Source: OECD and Bank of England.

Business cycle

slowdowns:

Dates of

easing cycle:

Months of

easing:

Fall in Bank rate over

easing cycle:

Jan 1980 - April 1981 Jul 1980 - Mar 1981 9 5.00pp

Jan 1984 - Nov 1985 Mar 1985 - May 1986 15 4.00pp

Nov 1988 - May 1992 Oct 1990 - Feb 1994 41 9.75pp

Nov 1994 - Sep 1996 Dec 1995 - Jun 1996 7 1.00pp

Jan 1998 - April 1999 Oct 1998 - Jun 1999 9 2.50pp

May 2000 - May 2002 Feb 2001 - Jul 2003 30 2.50pp

Jan 2004 - Nov 2004 None 0 0.00pp

Dec 2007 - Jun 2009 Dec 2007 - Mar 2009 16 5.25pp

Average: 16 3.75pp

Risk 4: Inefficient Allocation of Resources / Lower Productivity

Zombies

Liquidations, Interest Payments & Profitability

Source: ONS, Department of Business, Innovation and Skills and Bank calculations.

Company liquidations and interest payments

Company liquidations and loss-making companies

Source: Bureau van Dijk, Department of Business, Innovation and Skills and Bank calculations.

1990 1994 1998 2002 2006 2010 20145

10

15

20

25

30

35

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

Interest payments compared to pre-tax profits (RHS)

Liquidations as a percentage of active companies (LHS)

Per cent Per cent

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

15

17

19

21

23

25

27

29

31

33

35

0

5

10

15

20

25

30

Loss-making firms (rhs)

Company liquidations (lhs)

Per centThousands

Risk 5: Increased Vulnerabilities in the Structure of Demand

Consumption Growth and Savings Rates

Source: ONS and Bank calculations.

Consumption annual growth Savings ratio

19

98

Q1

19

99

Q2

20

00

Q3

20

01

Q4

20

03

Q1

20

04

Q2

20

05

Q3

20

06

Q4

20

08

Q1

20

09

Q2

20

10

Q3

20

11

Q4

20

13

Q1

20

14

Q2

-6-4-202468

Percentage change on a year earlier

19

98

Q1

19

99

Q2

20

00

Q3

20

01

Q4

20

03

Q1

20

04

Q2

20

05

Q3

20

06

Q4

20

08

Q1

20

09

Q2

20

10

Q3

20

11

Q4

20

13

Q1

20

14

Q2

0

2

4

6

8

10

12

14

Per cent

Household Balance Sheets

Household debt to income and deposits to income ratios

Distribution of mortgage debt to income ratios

1987 1992 1997 2002 2007 201250

60

70

80

90

100

110

120

130

140

150

Per cent

Debt to income(b)

Deposits to income(c)

Source: ONS and Bank calculations.

UK Current Account and Trade Balance

Source: ONS and Bank calculations.

1998 2000 2002 2004 2006 2008 2010 2012 2014-30000

-25000

-20000

-15000

-10000

-5000

0

5000Current account balance Goods and services

£ billion

Risk 6: Inequality

Inequality

Distribution of household financial assets by age group

Distribution of household financial assets

Key Distributional Effects of Lower Rates

• Boost asset values (equities)

• Reduce pension annuities, interest on savings & other fixed income payments

• Reduce mortgage, interest and other payments on borrowing

• Stimulate job creation

• Overall: Net effects on inequality unclear

Conclusions

Tying it All Together

(1) inflationary pressures

(2) asset bubbles and financial vulnerabilities

(3) vulnerabilities in the structure of demand

(4) an inefficient allocation of resources and lower productivity

(5) higher inequality

(6) limited tools to respond to future challenges

Mixed evidence,

further from MPC

mandate

Watch closely,

could soon factor into decision

Final Thoughts

King Midas washing away his touch in the River Pactolus