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 Range of DGI measures YoY inflation % 8.0 6.0 4.0 2.0 0.0 -2.0 -4.0 1998 2001 2004 2007 2010 2013 Source: ONS and Bank calculations. 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 UK business cycle slowdowns and Bank Rate: Source: OECD and Bank of England. UK: Bank Rate Adjustments During Slowdowns Business cycle Dates of Months of Fall in Bank rate over slowdowns: easing cycle: easing: 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 16 3.75pp Average: Source: OECD and Bank of England. Risk 4: Inefficient Allocation of Resources / Lower Productivity Zombies Liquidations, Interest Payments & Profitability Company liquidations and loss-making companies Company liquidations and interest payments Per cent Interest payments compared to pre-tax profits (RHS) 35 Per cent 0.8 0.7 30 Liquidations as a percentage of active companies (LHS) 25 0.6 Thousands 15 33 25 10 15 0.3 10 0 2002 2006 2010 29 27 0.4 0.1 1998 31 20 2014 Source: ONS, Department of Business, Innovation and Skills and Bank calculations. 25 23 0.2 1994 35 0.5 20 5 1990 Per cent 30 5 21 Loss-making firms (rhs) 19 Company liquidations (lhs) 17 0 15 1990 1993 1996 1999 2002 2005 2008 2011 Source: Bureau van Dijk, Department of Business, Innovation and Skills and Bank calculations. Risk 5: Increased Vulnerabilities in the Structure of Demand Consumption Growth and Savings Rates Consumption annual growth Savings ratio Per cent 14 12 10 8 6 4 2 Source: ONS and Bank calculations. 2014Q1 2012Q1 2010Q1 2008Q1 2006Q1 2004Q1 2002Q1 2000Q1 1998Q1 2014Q1 2012Q1 2010Q1 0 2008Q1 2006Q1 2004Q1 2002Q1 2000Q1 1998Q1 Percentage change on a year earlier 8 6 4 2 0 -2 -4 -6 Household Balance Sheets Household debt to income and deposits to income ratios Distribution of mortgage debt to income ratios Per cent 150 140 130 Debt to income(b) 120 110 100 90 80 70 Deposits to income(c) 60 50 1987 1992 1997 2002 2007 Source: ONS and Bank calculations. 2012 UK Current Account and Trade Balance £ billion Current account balance Goods and services 5 0 -5 -10 -15 -20 -25 -30 1998 2000 2002 Source: ONS and Bank calculations. 2004 2006 2008 2010 2012 2014 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 Watch closely, could soon factor into decision Mixed evidence, further from MPC mandate Final Thoughts King Midas washing away his touch in the River Pactolus