How durable will the present period of low interest rates turn out to be? Last week saw a new governor of the Bank of England, Mervyn King. Previous appointments, including that of his predecessor, Sir Eddie George, have perhaps been of more interest to the City of London than to the business community at large. But, since 1997, the post has changed radically. No longer is the Bank in charge of City regulation, for that is handled largely by the Financial Services Authority. But it is in charge of interest rates, which used to be determined by the Treasury.
The governor is, of course, only a primus inter pares on the Bank's monetary committee. So it would be wrong to ascribe too much control over rates to the chair of the committee. In any case, the fall in British interest rates has been closely associated with the fall that has happened elsewhere. Still, the personality of the governor is important because the financial markets will need reassurance during what looks like becoming an increasingly rough period.
That it is likely to be rough was indicated by the new governor in his first comments while in the job. He warned that the consumer boom was over as increased resources were funnelled into health care and other public spending.
This switch alone would make the business environment over the next five years quite different from what it has been over the past five. But there is another factor at work: the possibility of deflation.
Britain arguably has a lower probability of experiencing deflation than most other countries for two reasons. One is that British consumers are sensitive to interest rates. Thanks to the system of floating mortgages, changes in short-term interest rates feed directly through into people's bank accounts and hence to consumption.
The other is that sterling has weakened, at least against the euro though not against the dollar, at a convenient time. The fall will tend to increase demand for exports and curb demand for imports. So growth is likely to be maintained, removing one key reason for deflation: lack of overall demand. But demand will come from the public sector and from exports - hence the lack of a feel-good factor. This will have important implications for the business community.
The new governor is seen as a "hawk" on interest rates, for his voting record on the monetary policy committee has tended towards keeping rates up. But I don't think anyone should assume this means that there will be a tougher interest rate policy from now on. Rather the reverse. The Bank of England will seek to maintain domestic consumer demand, if necessary by cutting rates further, until it is clear that that baton of growth is taken over by exports and public spending. The Bank has to manage the transition.
It is a transition that could go wrong. There is evidence that consumption growth has already come off sharply, with the result that in the first three months of this year the economy barely grew at all. Private sector employment is falling. And much of continental Europe seems likely to fall into deflation, even if Britain doesn't.
So what should the business community expect? I suggest three basic assumptions.
The first is that the Bank under Professor King will be just as prepared to cut rates in the months ahead as it would have been under Sir Eddie George. It will continue to use the rapid feed-through of any such cuts into consumption to keep things going as it has in the past. So if the present slow-down continues we can assume that interest rates will drop further. My guess would be a further fall before the summer is out.
The second is that Professor King is right in warning of the end of the feel-good factor. Companies that depend on consumer demand will find they are continuing to have a tough time, maybe even tougher than at the moment. The economy as a whole will continue to grow but much of the growth will be in public sector services and exports. Firms that work for the Government, or are exporters, will be better off than those that are dependent on the home market.
And third, while rates will continue to be low for the foreseeable future, that will be associated with low inflation overall. Goods will continue to fall in price while services will continue to increase a little. And prices of assets such as houses, office blocks, shares and so on will languish for quite a long period.Reuse content