Interest rates: Why the era of cheap money is finally ending and what that means

Interest rates: Why the era of cheap money is finally ending and what that means

The Conversation

The Bank of England was widely expected to slightly increase its official bank rate on November 4, but it decided to stick to the all-time low of 0.1 per cent.

However, the bank has made it clear that a rise will soon be needed, and the recent increases in mortgage rates indicate that lenders agree. So why the decision to hold off?

The Bank of England is well aware of the distress that higher rates cause for borrowers and, in particular, for the biggest borrower in the land: the UK government. At the current level of national debt, roughly £2trillion, every rise in rates by one percentage point pushes up the interest paid by the government on its bonds by £20billion per year over the long term.

Higher rates also have a dampening effect on the prices of property and financial assets such as shares. Indeed, this is one way in which monetary policy is believed to work: if people feel less wealthy, they spend less and this relieves the pressure on inflation.

On the other hand, what’s bad for borrowers is good for savers. As rates rise, bank deposits will be better rewarded and even the finances of our beleaguered pension funds should begin to look more healthy.

But regardless of who wins and who loses from higher interest rates, inflation is on the rise. The bank does not want to lose credibility by letting it rise too far before tightening monetary policy.

The inflation dilemma

After rising for the past 12 months, UK inflation is currently 3.1 per cent, and the bank expects it could even reach an uncomfortable five per cent by early next year — much higher than its two per cent target.

Yet the bank maintains the view that this higher inflation will turn out to be temporary, arguing that it will fall back as the post-Covid excess demand for goods subsides and supply bottlenecks are worked out. Against that, energy prices are likely to remain higher, driven partly by climate initiatives; and if employers continue to have trouble filling vacancies, higher wages will also tend to push up prices.

The bottom line is that nobody really knows where inflation is heading, so the bank is wrestling with the usual dilemma: does it raise rates now to forestall future inflation, or does it hold rates down to avoid jeopardising the economic recovery while hoping that inflation will subside by itself? It can’t have it both ways.

Annual inflation 2019-21

This same dilemma is echoed in other countries. In the United States, the position is similarly troubling, with inflation already at 5.4 per cent against a two per cent target. Yet the Federal Reserve also continues to insist that the current high inflation is temporary, thereby justifying keeping its official interest rate (the Fed funds rate) near zero.

Yet the Fed is not completely sitting on its hands; it has announced that it will start ‘tapering’ its quantitative easing (QE) programme, in which it is creating US$120billion (£89billion) a month to buy US government bonds and other financial assets to help prop up the economy. From the middle of November, it will scale this back by US$15billion each month. This is at least an acknowledgement by the Fed that its excessively stimulatory monetary policy must eventually come to an end.

Back in the UK, the Bank of England has accumulated £800billion of government debt as a result of its own QE asset purchases, designed to stimulate demand particularly since the outbreak of Covid. At some stage, the bank will need to begin offloading this debt.

Its choices of when and how to do this present the bank with arguably an even bigger dilemma than the bank rate, because unwinding QE will drive up yields on bonds — thus directly raising interest costs for the government and all other long-term borrowers.

Yields on ten-year UK government bonds

In fact, yields have already started rising after many years of decline (see chart above). This is a sign that investors think that monetary policy needs to become tighter to curb inflation (by raising official rates and reversing QE) — which also explains why mortgage rates have already been rising.

This all confirms that the long era of ever-cheaper finance is finally over. The future will be tougher thanks to higher interest rates, or higher inflation, or both.

By John Whittaker, senior teaching fellow in economics, Lancaster University

Click here to read the original article on The Conversation

MORE: Bank of England ‘sorry’ for rising living costs

MORE: How businesses are preparing for a difficult winter

MORE: What is inflation and why does it matter

How to get your Metro newspaper fix

Metro newspaper is still available for you to pick up every weekday morning or you can download our app for all your favourite news, features, puzzles… and the exclusive evening edition!

Download the Metro newspaper app for free on App Store and Google Play

Source: Read Full Article

Previous post Instagram Is Testing Out a New “Take a Break” Function
Next post The Young and the Restless actor Jerry Douglas died aged 88
Lifestyle