Stephen King: Low interest rates can point to deep-rooted weaknesses

Interest rate cuts are back on the agenda. It's a surprising result, given how low interest rates already are. Not everyone has got there yet. Only two of the nine members of the Bank of England's Monetary Policy Committee have so far voted in favour of a rate cut. And, although Jean-Claude Trichet, the president of the European Central Bank, seems to be willing to think the previously unthinkable, his colleagues are likely to delay a move downwards in European interest rates until later this year.

The Federal Reserve doesn't even think US interest rates have peaked, but the soft tone to recent data suggests US rates are not going to rise a whole lot further. Some countries, though, have been brave enough to have acted already: last week, Sweden's Riksbank pushed rates down from 2 per cent to just 1.5 per cent, confirming that monetary policy can be loosened even when interest rates are already at remarkably low levels. Others are sure to follow suit.

The obvious question is "why"? We seem to be entering an increasingly unfamiliar world. Most central bankers carry some notion of interest rate "neutrality" in their heads. This rate is defined as the level consistent with price stability on an ongoing basis. If you'd asked most of them a couple of years ago where interest rates would have to be to achieve this magical "neutrality", I'm fairly sure the answers would have been, for the most part, at levels significantly higher than where we are today.

The territory we've reached is largely uncharted. Short-term interest rates seem to be peaking at levels in real, inflation-adjusted, terms well below what can be explained by economic growth and inflation.

Take the UK. No one can be too sure as to what the trend, or underlying, rate of real growth is but, in recent years, it's probably been between 2.5 and 2.75 per cent. The inflation target on the new, consumer price, measure is 2 per cent and, on the old, retail prices measure, was 2.5 per cent. Adding these bits and pieces together, you end up with a trend nominal growth rate of 4.5 to 5.25 per cent.

But, if UK rates have peaked at 4.75 per cent, and fall back to the previous trough of 3.5, the average level of base rates will have been a lot lower than nominal growth. A lot of economists, brought up on the tough monetary medicine of the 1980s, would be tempted to argue this is simply not possible: surely, they would argue, interest rates at these "accommodating" levels will only, in time, lead to inflation.

This argument is in danger of confusing cause and effect. Low interest rates are not the cause of high inflation; they are a consequence of low inflation and, for that matter, low inflationary expectations.

Two reasons account for this remarkably muted inflation performance. The first is obvious: central banks are a lot more credible now and no one seriously expects inflation to get out of hand again. The second is less obvious but no less important: globalisation has changed the dynamics of wage bargaining. No longer is it possible for workers to receive compensation for, say, higher petrol prices. Instead, they are more likely to get pay cuts as companies seek to offset the impact of higher energy prices on their profits through actual or threatened outsourcing.

Knowing that inflation is low is not good enough to explain fully why short-term interest rates are so low. Other things are happening. In continental Europe's case, weak domestic demand is partly a result of higher, demographically inspired, savings. Ageing populations are increasingly recognising that governments alone are unable to provide for retirement income so, instead, are simply refraining from spending. The weakness of economic activity that stems from this is enough to push interest rates down to unusually low levels.

In the UK's case, the hoped-for recovery in capital spending has failed to materialise. Companies are not short of cash but they seem unable to find worthwhile investment projects. Instead, they're returning money to shareholders, and so raising the level of national savings and, as a result, putting downward pressure on interest rates. Meanwhile, with the housing market softening, the consumer's appetite for more debt is dwindling fast, implying further upward pressure on savings and downward pressure on interest rates.

The US hasn't quite got there yet. Companies there, though, are under pressure to shore up their pension funds, another source of higher saving. And although consumers continue to spend freely, the industrial side of the economy is looking increasingly creaky. Overall, the US looks a bit like the UK a year ago: growing imbalances but a lack of transparency on precisely when the economy will begin to stumble.

Underneath all this is a failure to come to terms with the post-bubble world we are living in. The basic truth is that, post-bubble, life is tougher. No longer do people have the supposed guarantee of ever-lasting capital gains and, hence, endless jam today, tomorrow and for ever. But howhave we reacted to this new truth? Consumers pretended it wasn't there: they continued borrowing, helped along by rising house prices. Policymakers hoped it wasn't there: by setting interest rates at low levels, they created the illusion of ever-rising house prices to offset the earlier illusion of ever-rising stock prices. Pension funds assumed it wasn't there: they were happy to pretend the 1990s would return because otherwise their unfunded future liabilities would begin to look extremely daunting.

As reality dawns, there is a price to pay. High debt and low savings will be gradually replaced with low debt and high savings. As economies structurally come to terms with this change, interest rates will end up at very low levels. But low interest rates will not be an indication of monetary laxity. Instead, they will simply be telling us people would rather save than spend. Low interest rates might seem to be desirable but, in these circumstances, they point to deep-rooted fundamental economic weaknesses. Just ask anyone living in Japan.

Stephen King is managing director of economics at HSBC

stephenking@hsbcib.com