What’s the right level for interest rates?

02 October 2023

Interest rates seem to be at or near their peak for this cycle in the US and Europe. With inflation falling and growth likely to remain weak for some time, the focus is shifting to when central banks will cut interest rates.

If financial markets are right, material rate cuts are some way off. Markets see rates staying around current levels for roughly the next year, with only a gradual easing thereafter. The thinking seems to be that by avoiding deep downturns western economies will free up only modest amounts of spare capacity, so limiting the scope for major rate cuts next year. If things go wrong, and growth falls away more sharply, rates would almost certainly come down more quickly.

The big question is whether interest rates will end up settling at the levels that prevailed after the financial crisis. It seems like a distant memory, but between 2009 and 2020 the interest rate set by the US Federal Reserve averaged 0.7%. The equivalent rates for the euro area and the UK were just 0.5% (the current euro area rate is 4.0% and the UK base rate is 5.25%). Low rates were a product of a period of very low inflation that preceded the pandemic.

That era seems to have ended. Five factors that previously contributed to low interest rates now look less favourable.

First, geopolitical tensions and a greater focus on national autonomy have created new frictions and costs in the global trading system. The rapid globalisation of the 1980s, 1990s and 2000s brought down the prices of a vast array of manufactured goods. A more contested and uncertain phase of globalisation points to a weakening of such deflationary pressures.

Second, global demand for capital may be turning. Before the pandemic, investment ran at low levels in rich countries, depressing demand for capital and lowering interest rates. We are in a different world, one where a drive for resilience and sustainability, in energy, defence, technology and supply chains, requires vast levels of investment. The International Energy Agency estimates that global energy investment alone needs to rise from a current $2tn a year to $5tn a year by 2030 for at least 20 years to reach net zero CO2 emissions by 2050.

Third, demographic change raises inflationary risk. The deflationary dividend from the incorporation of China’s population into the global trading system has arguably run its course. China’s population is ageing and its working population is shrinking. In the West an increasing proportion of the baby boomer generation are no longer saving for retirement but are retired. While the labour force and output shrink, retired people obviously need to consume and do so by drawing down on savings and pensions. This, together with increased demand for labour intensive social and health services, reduces the pool of private sector workers and adds to wage and price pressures. (It is a measure of the challenges that the NHS estimates that its workforce will need to rise from 1.4m today to over 2.3m by 2036).

Fourth, surging inflation has called into question the reputation of central banks as guardians of stable prices, creating a further risk factor for long-term interest rates.

Fifth, central banks are switching from buying government bonds, which depresses interest rates, to selling them, which raises rates. The financial crisis caused Western central banks to undertake quantitative easing (QE), or the buying of bonds, on a vast scale to depress interest rates. Now the Federal Reserve, the European Central Bank and the Bank of England are selling bonds into the market, reinforcing the upward pressure on market interest rates from higher central bank policy rates. The stocks of bonds on central bank balance sheets are enormous, and the process of selling them is likely to take several years.

So, what does this all mean for long-term rates? Views and the weights attached to different factors vary. Some forecasters, such as the International Monetary Fund, think that rates will indeed return to previous lows. We see the risks lying in the opposite direction.

One profile is suggested by market pricing. Five and ten-year UK government bonds currently yield about 5.4%. Very simply, that suggests markets are pricing an average base rate of roughly 5.0% over the next 10 years, about the levels seen before the financial crisis. In the absence of much higher inflation or productivity growth, a 5.0% rate would be highly restrictive. For the UK, we see long-term rates running somewhere between that 5.0% and the 0.5% level seen before the pandemic. 3.0% looks a plausible number, though there’s no science in this. More important are the forces at work which, for me, do not point to a world of 0.5% interest rates.

OUR REVIEW OF LAST WEEK’S NEWS
The UK FTSE 100 equity index closed the week down 1.8% at 7,608.

Economics

Global trade volumes fell 3.2% in the year to July, contracting at the fastest pace since 2020, due to a slowdown in global demand
Bank of America's CEO Brian Moynihan said that he expects the US economy to avoid a recession and manage a “soft landing”
US consumer confidence fell for a second straight month in September driven by worsening labour market and income conditions
Credit ratings agency Moody’s expects US consumer spending to slow down as high borrowing costs discourage interest rate-sensitive spending
US house prices rose to record levels in July after increasing 5.3% since the start of the year, owing to low housing inventories
Euro area inflation fell to 4.3% in the 12 months to September, down from 5.2% in August. Core inflation also fell. The development increases the likelihood that the ECB will keep rates on hold when it meets at the end of the month
German business confidence fell for a fifth consecutive month in September, pointing to a contraction in GDP in the third quarter
France’s finance minister Bruno Le Marie announced smaller government spending cuts than anticipated despite France being projected to have one of the biggest budget deficits in the euro area this year
The poverty rate in Argentina increased to 40.1% in the second quarter of 2023 and extreme poverty rose to 9.3% as Argentines struggled with inflation which hit 124% in August
The Office for National Statistics (ONS) revised its estimate of UK GDP upwards – it now thinks that in the second quarter of this year the UK economy was 1.8% larger than its pre-pandemic size in the final quarter of 2019
Previously, the ONS had estimated that GDP in Q2 2023 was 0.2% below pre-pandemic levels. The development suggests the UK recovered faster than thought from the pandemic but doesn’t materially change the picture of slow growth over the last two years
The Bank of England wrote to UK lenders warning them that their predicted loan losses may not account for the impact of higher inflation and interest rates on borrowers
The Bank also reported that UK money supply had shrunk in August, the first contraction since comparable statistics began in 2010 – the development may ease inflationary pressures
The Institute for Fiscal Studies said that this parliament is likely to have overseen the largest rise in taxes on record

Business

Nissan’s CEO Makoto Uchida said that “the world needs to move on from internal combustion engines” as the company announced it would only sell electric vehicles in Europe by the end of the decade
Toymaker Lego abandoned efforts to replace oil-based plastics in its products with those from recycled PET bottles after finding that the new material led to higher carbon emissions
London's Gatwick Airport cancelled more than 160 flights last week and imposed a cap of 800 flights per day due to staff shortages
Discount supermarket Aldi announced it would increase investment in the UK to more than £1.4bn over the next two years and open another 500 stores
The US Federal Trade Commission accused Amazon of using “a set of interlocking anti-competitive and unfair strategies” to maintain monopoly power
US retailer Target announced it would close nine stores due to high levels of “theft and organised retail crime” in some locations
Online retailer Asos downgraded its earnings forecasts after sales slumped by 15% in the last quarter due to wet weather this summer
Housebuilding in England jumped 75% over the second quarter of this year as builders brought forward projects to avoid new energy performance regulatory standards

Global and political developments

Russia exempted bunker fuel, gas oils and middle distillates from its indefinite export ban which has increased diesel prices in the last few weeks
US Senate leaders struck a “temporary” deal to avoid a government shutdown and provide funding for Ukraine’s war effort as well as disaster relief for US states hit by wildfires and floods
UK regulators approved plans for a new oilfield in the North Sea, despite criticisms from climate campaigners
The president of Nagorno-Karabakh announced that the republic will cease to exist from 1 January 2024 after Azerbaijan retook the region in a blitz assault

And finally… Britain's biggest card seller, Card Factory, reported that said cards from pets were the fastest growing category across certain occasions and that it is looking to expand its range of cards from cats and dogs - target bark-et

Back to News listing