12 April 2023

Are zero interest rates coming back?

Did the IMF really predict the return of zero rates, or has it been misread?

Borrowers across the country breathed a sigh of relief yesterday as the BBC, Sky News, the Telegraph and the Mirror reported the International Monetary Fund’s prediction that we will soon see the “return of ultra-low interest rates” in the near future, “once high inflation is brought under control”.

Such headlines, accompanied either by pictures of houses or people looking at the paperwork involved in paying for a house, gave the clear impression that mortgages will get cheaper because central banks, such as the Bank of England, will bring them back near zero when inflation goes down. (Headline inflation will drop sharply soon, because headline inflation is a year-on-year figure, and the very large rise in the energy price cap that took place on 1 April 2022 is now more than a year in the past.)

But this isn’t what the IMF predicted. Its blog, which was based on the findings of the IMF’s World Economic Outlook (also released yesterday), concerned “real” interest rates, which are changed by inflation. If inflation is ten per cent and you have a four per cent mortgage, your debt is growing more slowly than the cash in your wallet is shrinking, so the real rate of interest on your mortgage (the amount its purchasing power changes) is negative.

Real interest rates are harder to pin down than the solid numbers of bank rates, but within them can be found what the economist John Maynard Keynes called the “natural rate of interest”: the Goldilocks zone at which the cost of borrowing neither stimulates nor depresses the economy. The IMF’s economists explain that this has changed a lot. In 1979, we can say it was very high in the US, because even a bank rate of 10 per cent didn’t slow down inflation, and in 2008 we know it was very low, because even with a 0.5 per cent bank rate, debt wasn’t cheap enough to support economic growth. The IMF’s long-term prediction (to 2050) is that this will remain the case.

What the IMF was really saying, then, was that advanced economies haven’t become capable of more growth than they were prior to the pandemic. As a headline, this would not have made it to the top of the Most Read box on BBC News, but it would at least have been accurate.

“What the IMF is saying,” explains Simon French, head of research at the investment bank Panmure Gordon, “is that the reasons why interest rates were very low for 15 years are still intact today.” These reasons include an ageing population, new technologies, a high debt burden and high income inequality, factors that are common across advanced economies. “It’s illustrating the fact that the world economy, and even China and India, is reaching, if you’re being kind, middle age – and if you’re being unkind, slightly sclerotic old age.”

There is, French says, “nothing wrong with the IMF’s thesis”, which is, he says, “very intellectually robust… but as a signal for households about where their rates are going, it’s kind of irrelevant”.

It’s not completely wrong to say that “interest rates” (by which I mean the bank rate set by the Bank of England, on which the price of other debt such as mortgages is based) are going to fall as inflation drops. Bond markets are pricing in modest reductions in bank rate, late this year or early next year. Some economists, such as Silvana Tenreyro (a member of the Bank’s rate-setting committee), think this will need to happen sooner. But either way, persistent inflation means mortgage holders are not going to enjoy a hazy, crazy summer of 1.5 per cent interest.

This could present a(nother) communications problem for the Bank, which was criticised for responding slowly to inflation, and may soon be admonished for holding rates high when headline inflation has plummeted. But while core inflation (which rose in February) remains high, bank rate will need to remain strong against it.

It’s a little irresponsible to give people the impression that the high times of low rates will be back soon; the cost of servicing mortgage debt is for many people their biggest expense and they will be planning accordingly. But it also ignores that low rates aren’t actually desirable. The problem that the IMF blog was trying to explain is that the UK and other advanced economies cannot grow sustainably at the same rate that they could in previous decades. Low growth makes the decisions governments take on what they spend and who pays for it (through taxes) harder and more contentious.

The good news, says French, is that while some factors that dictate the natural rate and the economy’s growth potential can’t be helped (we don’t want everyone to stop living longer, for example), some of them can: “If we make decisions on trade protectionism, on the energy transition – those pathways for the natural rate will look very different. It’s all up for grabs.”