What people get wrong about interest rates

Last week the Bank of England raised interest rates for the first time in 10 years.

Last week the Bank of England raised interest rates for the first time in 10 years.

The base rate — the interest rate on which others are based — went up from 0.25% to 0.5%.

0.5% is still very low by historical standards. For the last 30 years the base rate has averaged about 4%. So the rise this week is getting rates back up to more normal levels.

Why should you care? Interest rates matter a lot. Rates determine how much money you make on your savings, how cheaply you can take out a mortgage, how businesses invest, the exchange rate, house prices, the stock market, and more.

Are low rates “better” than high rates? Impossible to say. Low rates and high rates benefit / hurt different groups of people. It follows that there is always a group of people who are unhappy about interest rates. When rates were very high back in the 1970s and 80s, it was tough to get a mortgage. Now that they’re low, savers are rightly annoyed. According to M&G, £1,000 left in a deposit account in 2007 would now be worth just £789 after inflation.

You could certainly make the case that overall, the UK was better off when rates were higher. Less debt sloshing around, better returns in savings, lower house prices. So if you think higher rates are a good thing, then it must follow that the Bank of England’s decision to raise rates is a good thing. Right?

Not quite. Things are never simple when it comes to monetary policy.

There are two ways of looking at the job of a central banker.

According to the “bus driver on a windy road” school of thought, Mark Carney has the freedom to steer interest rates the same way a bus driver has freedom to veer off a windy road. The bus driver/central banker might be literally in charge of turning the wheel/setting interest rates. But in reality, the road/economy tells the bus driver/central banker which direction to go.

In other words, Mark Carney is being told by the economy where to put interest rates. Not the other way around. If Carney were to raise rates too suddenly or too soon, it’s likely we’d have a big recession. Like a bus driver reversing out of a ditch, he’d have to lower them again. He’d have to get back on the road.

The “road” Carney is driving is set by the unemployment and inflation levels. They’re the ditches on either side of him. If inflation goes above 2%, Carney will be under pressure to raise rates. Or, if unemployment is too much above 5%, Carney will be under pressure to lower rates. The Central Banker is trying to pick a path that keeps those two numbers in balance.

The best recent example of a central banker driving into the ditch comes from the European Central Bank in 2011. In 2011, the European economy was still very weak. But the ECB was paranoid about inflation, so it raised rates by half a percent (in central bank land, that’s an aggressive move). The decision backfired terribly. The eurozone economy crashed, the ECB had to reverse out of the ditch by lowering rates again. The Japanese Central Bank made the same mistake in 2001. And in the 1970s, central banks messed up in the other direction by cutting rates despite high inflation. The end result is always the same — after admitting the mistake, they go back to where they started.

So that’s how I see things. I think the road tells Mark Carney where to drive.

Lots of people see Mark Carney’s job differently. They think central banks have true control over interest rates. For them, there’s no road. Mark Carney is whizzing about on a speedboat on an open lake, free to turn whichever direction he wants.

According to this view, central bankers aren’t so much interested in staying on the road as interested in which group should be “winning” — savers or borrowers, home owners or homebuyers, governments or citizens, exporters or importers. These people seem to think that Mark Carney could click his fingers and before we know it we’d be back in the 1990s, with interest rates at 4%.

That idea seems to make sense… until you look at all the times in history central bankers veered off course. It doesn’t ever work. The central banker always ends up back where they started, having caused a lot of trouble.

So if I’m right, and the economy is setting the direction of interest rates… where are interest rates going? Why are interest rates so low? And are they going to stay low?

That’s a full topic in itself. I’ll keep it for tomorrow.

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