These are extraordinary times for the UK economy, and that has been reflected in the Bank of England’s monetary policy, with the official interest rate still at its lowest level ever. It’s no wonder there is much uncertainty about what happens next: recovery or depression, inflation or deflation? All would produce different answers for interest rates, with significant implications for both borrowers and savers.
First though, let’s review the current situation. After 15 straight years of growth, the UK economy is now in the grip of a recession which has threatened to set new records. The response to the global credit crisis has been massive government intervention. In the UK, we have seen huge fiscal stimulus, with vast budget deficits, and interest rates cut to almost zero. Together with the efforts of governments around the world, this appears to have been enough to avert any re-run of the Great Depression. However, this still leaves the UK – and the global economy – in a recession. Moreover, the forecast recovery is set to be hampered by several factors: the scale of the budget deficit; the level of consumer debt; the damaged banking system; and new regulations which are intended to prevent any future bust but are likely to impede growth.
Against this background, Coutts forecasts that interest rates will stay low for an extended period. However, the position has been complicated by the introduction of Quantitative Easing (QE), or ‘printing money’. Rate cuts work by making it more attractive for households and businesses to borrow more money which they then spend or invest and thereby make it less attractive to save. Yet rates cannot go below 0% (as depositors would just withdraw their money), and most financial systems require a certain minimum interest rate to function. So, after cutting rates to 0.5%, the Bank of England moved to QE. If they couldn’t make money cheaper, they could at least increase the amount in circulation, by creating money and using it to buy government bonds. This appears to have succeeded in stimulating the supply of money and avoiding deflation.
Future growth?
Thanks to this surge of additional money into the financial system – as well as the budget stimulus and very low interest rates – we forecast a return to growth late this year. Yet the recovery will face considerable headwinds and will probably remain weak, with growth next year not much above the consensus forecast of 0.8% for the UK and 2.1% for the US. If that turns out to be the case, it won’t be strong enough to drive an early rise of interest rates. In any case, the Bank of England will also need to take back the QE, by draining the money it has created from the system (£175 billion, as of August 2009). Therefore, we expect UK rates to stay at current levels for another year before rising very gradually.
The main risk to this view would be any steep rise in inflation. QE has rarely been used before, so its impact is uncertain, and the Bank of England may be too slow to raise rates in the face of inflation pressures, given the weakness of the economy. Normally, the level of spare capacity in the economy – for example, the high unemployment rate – would militate against wage rises and other forms of inflation. However, if growth comes from new areas (rather than its previous dependence on financial services), the new economic cycle may reveal unexpected shortages which would generate inflationary pressures.
So there appears to be a much higher chance of inflation than deflation over the longer term. This suggests that current interest rates are attractive for borrowers, subject to the availability of credit, but that depositors should be reluctant to lock in current rates or should seek inflation protection.
Further information
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Further Information
