A long low note

Why interest rates can be expected to stay low for years

CENTRAL bankers have a reputation for snatching away the punch bowl just as the party gets going. So, almost as soon as Britain's economy started to recover, commentators and markets started fretting about when interest rates would rise. Mark Carney, the Bank of England's governor, has tried to soothe them with “forward guidance”, in effect promising to hold off until the economy recovers. But Mr Carney also whispered something else: that rates would stay unusually low even when they do budge. The punch bowl will go, he suggested, but there will still be plenty of booze around.

The bank believes Britain's “equilibrium interest rate”—the rate needed to keep inflation and economic growth on an even keel—is being depressed by three things. One is the ongoing fiscal contraction. With the state using a shrinking share of resources, the private sector has to expand faster to take up the slack. A lower interest rate is needed to achieve that.

The second has to do with the country's convalescing banks. During the crisis the spread between the central bank's policy rate and the interest rates commercial banks charged their customers for loans jumped. Although the spread has fallen since, it remains much higher than it was before the crisis. So the Bank of England need not raise its rate so high to generate a given level of private-sector interest rates.

The final factor is the rest of the world. Britain's openness, through trade and finance, ties it to foreign economies. The euro-zone crisis has hit the country's exporters and banks. “Secular stagnation”, a notion recently popularised by Larry Summers of Harvard University, might also be at play: falling investment demand in advanced economies, combined with a glut of savings in emerging markets, has pressed down on equilibrium interest rates throughout the world.

These pressures seem unlikely to abate soon. Britain's major political parties are all committed to eliminating the fiscal deficit over the next parliament. Credit spreads are unlikely to shrink to their pre-crisis lows, which reflected an overly sanguine attitude to financial risk. The euro zone faces a lengthy slog back to health. And if, as Mr Summers suggests, global stagnation persists, the downward pressure on Britain's equilibrium interest rate might even increase.

A persistently low bank rate would be bad for savers but a boon for borrowers. Britain's 9m or so mortgage-holders are sensitive to the bank's policy rate: the average new mortgage is fixed for just two years (compared with 27 years in America) after which it tends to track the bank's rate. Matthew Whittaker of the Resolution Foundation, a think-tank, calculates that the difference between a bank rate of 3% in 2018 and a rate of 5% is that 620,000 fewer households would be in “debt peril”, defined as spending more than half their disposable income on debt payments.

The prospect of rates remaining low for years should also improve companies' behaviour. British investment is startlingly weak at present—still 20% below its pre-crisis peak, and lower than in any other G20 country as a share of GDP. The expectation of more cheap finance, together with dwindling spare capacity and rising demand, ought to entice firms to build and buy. The Bank of England predicts an extraordinary 43% rise in business investment by 2016, which would boost both demand and productivity.

But a low equilibrium interest rate should make Mr Carney nervous. Bank rates cannot easily be cut to below zero. A new normal of 2-3% would thus leave the bank with little space to cut rates when future shocks hit. Britain's emergency monetary experiments, such as quantitative easing and forward guidance, are known as “unconventional”. In time they could become part of the new normal, too.