Yesterday I called out the biggest mistake I see people making when they talk about interest rates.
They see Mark Carney raising rates, like he did last week. And they say he was “long overdue”… or that he’s been “manipulating” interest rates. As though it’s entirely his decision to make.
I said yesterday, “Mark Carney has the freedom to steer interest rates the same way a bus driver has freedom to veer off a windy road.”Technically, he can do it. But that misses the point.
In reality, central bankers set rates where the economy tells them to. If they tighten when inflation is low they’ll cause a recession. If they loosen when inflation is high they’ll make it worse.
So if interest rates are much bigger than Mark Carney or the Bank of England, where do they come from?
Why are they so low? And what direction are they going?
Where interest rates come from
Interest rates’ job is to balance out the supply and demand for money.
When you put money in your savings account, it doesn’t just sit there like a car parked in a garage. The bank takes your money and loans it to another fellow to buy a house. That’s how banks make a profit. They pay you 1% to hold your money, then they charge the borrower 3% to borrow it.
Easy money, right? The old joke was that banking was a 3-6-3 business — pay depositors 3, lend at 6, tee off on the golf course by 3.
Interest rates are the price that keep the supply and demand of money in balance. High enough that savers want to save, low enough that borrowers want to borrow.
It’s hard to say what’s going on just by looking at a change in the interest rate. That’s because, for example, interest rates can rise because the demand for borrowing goes up, or because the supply of savings goes down. And interest rates can fall because the supply of savings goes up, or because the demand for borrowing goes down. Or any mixture of the lot!
To figure out what’s actually causing a change in rates, you need to know what’s happening behind the scenes with the supply and demand for money.
The savings glut
Low interest rates aren’t new. They have been falling all over the world since the 1980s, when the average inflation adjusted interest rate was around 5% according to a study by Mervyn King.
Since then they’ve slowly, steadily fallen. They eventually hit the zero mark after the crash in 2008, but this is story is much older than that.
So what’s changed? According to the basic supply and demand model, rates fall when there’s either less demand for borrowing or more supply of savings.
There’s been loads of demand for borrowing over the last 30 years. Households, businesses, banks and governments have all greedily taken on more debt in that time. That’s probably not the culprit.
The supply of savings is a different story. According to a 2015 report by the International Centre for Monetary and Banking Studies, interest rates are being lowered by a huge global “savings glut”.
Two things are causing the glut. The first is China. China is now the world’s biggest economy in nominal terms. And Chinese people save about 40% of their income. That’s a huge addition to the global supply of savings. That on its own is enough to push down rates significantly.
The second factor is ageing populations here in the West. People here are living longer, but not working longer. That means they’ve to put away more money for retirement. The amount of savings is going up every year because most people save heavily in their peak-earning middle age years.
So that’s what’s going on with interest rates. They’re low because a billion extra people have started saving, and because the West has started saving extra-hard for retirement.
That tells us what’s happened so far. But what’s going to happen next? Are low rates here to stay?
According to Lars Christensen, a monetary economist, you shouldn’t expect rates to rise much any time soon. According to Christensen, rates should stay low for three reasons.
The first is the story you’re already familiar with — ageing populations. Ageing populations show push interest rates down by up to 1.5% by 2027 in most major economies (apart from Japan, which will be over the demographic “hump” by then).
The second reason is to do with new bank regulation. After the financial crisis, new rules were passed which force banks to hold lots of safe, low interest-rate assets. According to Christensen, that’s pushed down interest rates by between 1-1.7%.
And the last reason is to do with inflation. There’s a relationship between the amount of inflation people expect, and the interest rate (it’s called the Fisher Equation). What it means is, low inflation expectations translate into low interest rates. For the last ten years, there’s been very little sign of inflation, and there’s not much sign of it now (apart from Brexit-induced UK inflation).
So there you have it. Central bankers don’t control interest rates, except in the short run. Rates are low because there’s a huge glut of extra savings in the system. And they’re likely to stay low because of new banking rules, low inflation, and ageing populations.
Interest rates and monetary policy is good fun because smart people have very different takes on it. So if you think I’m flat out wrong, or if I’ve missed something, let me know. Email me at Sean@agora.co.uk.