Britain set for new era of low rates, says Bank Governor

Britain may be on the brink of a new era of low interest rates thanks to the slump in long-term borrowing costs, the Governor of the Bank of England said last night.

Mervyn King said global capital markets could be returning to an era of low real rates "more akin" to the 19th and early 20th centuries. But he warned the surge in risky asset prices driven by investors' search for returns in a low-rate environment could suddenly unwind, delivering a shock to the world economy.

In a speech to Kent business leaders, Mr King said the fall in long-term interest rates was one of the three key "signposts" for central banks - the others being the fall in manufactured goods prices and the surge in oil costs.

But he admitted central bankers were unsure about what had driven the fall in long-term rates - and how they should react if it ended with an economic shock. He said that investors had been increasingly willing to lend to governments at low rates in the past three to four years, highlighting a real rate on UK 20-year bonds of 1 per cent.

"If annual market rates on index-linked securities in the UK were to remain around 1 per cent, then with a 2 per cent inflation target the level of official interest rates required to balance overall demand and supply would, in the long run, be lower than thought necessary in the past few decades."

However, he said the picture was confused by doubts over what had driven these rates to such low levels, highlighting two explanations. The first said it was driven by an increased propensity to save and by the demand for long-dated products spurred by concerns over ageing populations.

But the phenomenon could have been driven by investors' "search for yield" in a low-rate environment. "Across the world, the prices of all kinds of assets have risen ... and the expansion of money and credit may have encouraged investors to take on more risk than hitherto without demanding a higher return."

"At some point the ratio of asset prices to the prices of goods and services will revert to more normal levels," Mr King added. He said this could occur through a slump in asset prices or a surge in inflation of goods and services prices. "In neither case would it be easy to keep inflation close to the 2 per cent target," he said.