If anyone, five years ago, had said that home loan rates would be back to the level of the 1960s, they would have been greeted with a mixture of disbelief and jubilation. But, of course, it is not like that at all. The interest rate cut has seemed to most people more like a modest but hard-earned relief from the grind of indebtedness. It comes less as an invitation to rush out and borrow big than an opportunity to compensate for past excesses.
The reason is that this fall in interest rates is associated with, but has lagged behind, a fall in world-wide inflation. I conducted an experiment last week at a conference of management consultants outside Chicago. Would, I asked them, the general level of prices in the US be higher or lower in the year 2020 than it is today, or about the same? More than 40 per cent reckoned that prices would be lower, with the rest split pretty evenly between higher and about the same.
So, among this sophisticated audience at least, there was an expectation that there would be no inflation in the US over the next 25 years. I do not think one would get the same response here. Our markets suggest inflation at 3 to 4 per cent over this period. But the idea of zero inflation is not so odd if you recall recent behaviour of prices here and abroad.
It's not just a question of British house prices being lower than they were in 1988. Lots of other prices have come down: the oil price, telephone calls, just about any form of electronic equipment, and so on. We talk as though inflation were a normal condition. People still expect annual increases in salary (though these days they do not necessarily get them). When the CBI polls its members, the majority say that they expect to put their prices up (though increasingly often they are disappointed).
Seen in this context, our interest rates, far from being low, are actually quite high. A mortgage rate of 7.5 per cent may sound wonderful compared with the double-digit rates of yesteryear. But it is a killer if house prices in 25 years are going to be no higher in money terms than they are today.
As for credit card rates, some of them already seem outrageous. This month's Which? survey on credit cards reported interest rates ranging from 14.5 per cent to 29.8 per cent - yes, 29.8 per cent.
Adjusting to the idea that the normal range for base rates will be perhaps 2.5 to 7 per cent - and that good-quality borrowers should be about to obtain loans a couple of percentage points above that - will be one of the big changes in perception which we will face.
Some of these changes are clear enough. From the point of view of the financial institutions, low interest rates mean that they have to earn their money in different ways. It is not just those credit card rates that will seem increasingly ridiculous; there are more technical changes in the world of finance which low and stable interest rates will bring.
The most obvious example is the decline in the endowment effect of the interest-free current account balances held by the clearing banks. Interest- free money is much less profitable in a world where interest rates are in low single figures than one where rates are in mid-teens. So banks have to find other sources of income: witness the way they now charge fees for services they used to deliver free.
There are other, similar effects. At the moment the building societies earn a lot of their profit from the timing of interest rate changes: when rates come down, they announce a cut in loan rates ahead of a cut in deposit rates. But actually they impose the cut on deposit rates before the cut in loan rates. When rates go up, the reverse happens. This gap is very profitable, so in an ideal world they need lots of changes in rates. But a world of lower rates will also, in all probability, become a world of more stable rates, so the opportunities for exploiting this gap will be much reduced.
There will be a more general impact on the company sector. Low interest rates mean cheap money on investment, but low inflation means lower returns on that investment. The Bank of England has criticised British industry for failing to downgrade its expectations of what an acceptable rate of return might be. Gradually a more stable financial environment will affect company behaviour. The promise of low inflation is less persuasive than the actuality of low long-term interest rates. Once companies can raise 20-year funds at, say, 6 per cent, they will start to find projects which yield, say, 12 per cent attractive again.
There is a further point here, for the issue is not just a transitional one between high and low inflation periods, or of positive or negative real interest rates, or even of uncertainties about the transition from one condition to another. High interest rates and high inflation go together, so in theory real rates of interest can be positive or negative under each condition. But a high inflation/ high interest environment is different to a low inflation/ low interest rate period because mathematically high interest rates load the burden of repayment on to the early part of the loan. You have to pay the high rate of interest from day one, whereas by the end of the loan those same nominal payments have become very small in real terms. Anyone who took out a mortgage in the late 1970s or early 1980s will have experienced this.
The effect of this "front-end loading" is to force quick pay-backs. So big capital projects are discouraged; building standards have to be skimped; quality in anything is hard to justify financially. By contrast, in a low interest rate/ low inflation world it is possible to do jobs really well. The Victorians built to last for ever, not because they had some temperamental imperative to do so, but because they could borrow the money cheaply.
For ordinary people, the low interest rate environment should have similar effects. There is much less likelihood of losing money by keeping it on deposit. Though nominal interest rates may remain low, the thing which really destroys savings is inflation. As the chart on the left shows, in the early 1990s returns on cash have reached levels not seen since the early 1930s.
As borrowers, though, we should be careful until interest rates really do reflect low inflation. In the last few years British companies have cut back their borrowing, but we as individuals (see right-hand graph) have not. Perhaps we have not yet adjusted to the new normality. Lenders think we haven't. Look at the rates of interest advertised for credit cards or new-car finance schemes. Next time you see the word "only" attached to an interest rate of more than 10 per cent think what our grandparents would have thought of that, before you take up their kind invitation.Reuse content