Interest rates, growth and outlook from The Times

Philip Aldrick, 18th Feb 2015

It’s easy to think that the Bank of England is all-powerful when it comes to interest rates. It’s what we’re supposed to believe, after all — that the nine members of the monetary policy committee lock themselves in a room for a day and half every month to decide what the rest of us should pay on our debt. Only it doesn’t quite work like that.

Take mortgage rates today. At 2.01 per cent for a two-year fixed deal with a 25 per cent deposit, home loans are cheaper than they have ever been. Yet the Bank has not touched rates since March 2009 and its £375 billion quantitative easing programme has been unchanged since July 2012. Back in March 2009, the same two-year fixed deal cost 3.98 per cent and was still 3.67 per cent in July three years later.

It’s not only mortgages. Last month, the Treasury borrowed £3 billion from the financial markets for 43 years through an inflation-linked bond. Remarkably, the effective interest rate was -0.8955 per cent. In other words, the pension funds and insurers lending to the government are paying for the privilege. The last time I looked, official rates were 0.5 per cent.

The truth is that bond markets set UK rates. The Bank merely guides them. Lately, though, they have been far more distracted by events beyond the monthly “no change here” decision from the MPC.

The collapse in market rates is perhaps the biggest issue in global economics right now. While homeowners and the government may be enjoying cheap borrowing costs, a darkness is lurking.

Bond markets are pricing stagnant world growth for generations. If they are to be believed, we’ve reached the end of progress. As the negative rate on that “linker” demonstrates, investors are so scared of losing their principal, they will pay to preserve it rather than risk it for income. Capitalism’s “animal spirits” are dead.

Far-fetched as it seems, a negative mindset has set in that risks becoming self-fulfilling. Problems in the eurozone, global disinflation and fears of stagnation have gripped the markets’ collective imagination. There are fears that the advanced world is going the way of Japan, where growth practically flatlined for two decades after deflation set in and is now failing to respond to massive amounts of stimulus in the form of QE and government spending.

The psychological turning point can be traced back to the International Monetary Fund’s annual meeting in October last year, when it cut its global GDP forecasts and warned that the world may never see its pre-crisis pace of growth again. Stock markets sold off in the subsequent weeks as investors piled into safer government debt.

Such risk-aversion is dangerous because risk-taking — the “animal spirits” — is what drives growth.

Just like the Great Depression of the 1930s, when levels of entrepreneurialism sank, the scars today from the financial crisis are deep. “People are looking for reasons not to do things, rather than do things,” as one UK policymaker said.

There are good reasons to believe that the markets are wrong. Far from stagnating, technology optimists such as Andrew McAfee believe that the world is entering the “fourth industrial revolution”, where robotics and 3D printing vault us forward once again. The past 300 years of history would support the optimists, too. Entrepreneurialism did take off again after the Great Depression.

For that to happen, investors need to put their money on the line again. Until they do, though, there will still be winners. Foremost among them is George Osborne. Slumping market rates are driving down government borrowing costs, which, alongside dwindling inflation, promise to deliver the chancellor a bumper windfall in the March budget. 

In December’s autumn statement, cheaper market rates than projected in March knocked £7 billion off the 2018-19 budget deficit. That reflected a fall in ten-year gilt yields from 2.9 per cent to 2.1 per cent. Since December, they have dropped further to 1.6 per cent. 

The Bank of England has also cut its inflation forecast for this year by about a percentage point, which the Office for Budget Responsibility estimates will save the Treasury £3.6 billion on those “linkers” — inflation-indexed government debt.

Between them, the changes to market rates and inflation could deliver almost two fifths of the Tories’ £25 billion of uncosted austerity planned for the next parliament and mean that neither Labour nor the Liberal Democrats would have to find any further savings. 

The only thing that could turn the chancellor’s smile into a grimace would be if the OBR bought into the bond markets’ bleak outlook for growth.

If nothing else, all this goes to demonstrate the power of both belief and the human imagination — as, ultimately, markets are no more than the people who shape them. Homeowners are better off and austerity may be stayed.

In the end, that’s far more potent than a committee of nine people meeting every month on Threadneedle Street.