Friday, November 6, 2009

Prospect of 0% Interest Rates into 2010

The current recession is the longest recession since records began in 1955. It is the deepest since the great Depression of the 1930s. The fact it could have been much worse is scant comfort.

The economy is being propped up with low interest rates, tax cuts, a weak pound and quantitative easing.

Amidst the gloom, there are some signs of recovery. Manufacturing output rose sharply in September (after a sharp fall in August) Confidence has improved somewhat. New car sales (helped by government's scrapage scheme) have risen by a third. All this suggests GDP statistics for the last quarter might be wrong, and could be later revised upwards. Yet, few expect a recovery to be anything but anaemic, and combined with a dreadful fiscal position it creates a strong likelihood of low interest rates.

Rising oil prices and a weak pound will push up the headline inflation rate. But, the Bank needs to learn from its mistake of early 2008 - paying too much attention to temporary oil price induced inflation. Apart from these temporary factors, underlying inflationary pressures will remain muted. They will remain muted because unemployment will remain high and there is considerable spare capacity in the economy. Whilst spare capacity exists and inflationary pressures remain muted, the Bank can keep interest rates low.

At the same time, there will need to be some tightening of fiscal policy (higher taxes) (e.g. VAT will go back up to 17.5% - reducing consumer spending).

These tax rises, could reduce spending and derail the recovery. This deflationary impact of higher taxes makes even less chance for interest rate increases in the near future. It is quite feasible that interest rates could remain at 0.5% for the duration of 2010.

As other countries start raising rates, Low UK interest rates could further weaken the Pound. But, I don't think the government / MPC will be concerned about that. A weaker pound will just be another tool in helping the economy to recover. They may not like to admit it, but the monetary authorities seem to have a policy of 'benign neglect' towards Pound Sterling.

During the recovery, any inflationary pressures would justify a tightening of fiscal policy before monetary policy. Government borrowing is uncomfortably high. Government borrowing needs tackling in a way that doesn't create a second downturn. It makes a convincing case for loose monetary policy (0% interest rates, quantitative easing) and tightening of fiscal policy when the economy is able to absorb it.

The other factor is that the economic crisis has arguably changed consumer attitudes, the economy has gone from an economy of borrowers to an economy of savers. Another reason why inflationary pressures will remain muted and interest rates low.

At least some will benefit from the current economic situation. Now, if only I had bought a tracker mortgage in 2007....


Anonymous said...

I want to quote your post in my blog. It can?
And you et an account on Twitter?

Tejvan Pettinger said...

Yes, you can quote post, but, please give link to original article.

sorry no twitter at moment.