Economics Weekly - How low can official interest rates go? Weekly economic data preview - Will the BoE cut interest rates again next month?
Economics Weekly 10 November 2008
How low can official
interest rates go?
Slowing economic growth
and falling inflation is leading to record low interest ratesâ€¦
Interest rates are
being cut aggressively around the world as economic growth slows and as price
inflation either falls back from recent peaks or is set to fall sharply in the
months ahead. A worsening of the credit crisis since the failure of Lehman
Brothers two months ago, has noticeably hit expectations for growth and
inflation. In many countries, prospects for price inflation are helped by the
fact that wage inflation is well-behaved, meaning that it is well below price
inflation. How low can interest rates go in some of the major economies? One
starting point is the approach used in the so-called â€˜Taylor ruleâ€™, which calculates
the extent to which inflation and growth deviate from their long run averages,
subtracts this from long run real interest rates and then adds expected
inflation to get an estimate of what the short term official interest rate
should be. We have calculated these rates for the US, UK and eurozone. What do
they show? The answer is that overall they show that interest rates in the
advanced economies have a further 1 to 2 percentage points to fall.
An analysis of the
results from calculating Taylor rule rates for the US reveals an official
rate of 3.75%, well above the current interest rate of 1%, see chart b. But
central banks set short term interest rates in a forward looking way and, if
this is taken into account, then it explains why there is such a large gap between
the two rates. But in order for that calculation to work, we have to assume that
price inflation falls well below its long term average, and that the economy
weakens further, so that a big negative output gap opens up. This is, of
course, exactly what forecasts are suggesting and so doing this largely
explains the gap between the actual central bank base rate and the Taylor rule rate. IMF
forecasts now show that growth in the advanced economies will be negative in
2009, the first synchronised decline since the second world war.
â€¦analysis using the â€˜Taylor ruleâ€™ suggests that
interest rates can be cut furtherâ€¦
So assuming more
negative forecast outcomes for economic growth and inflation into a Taylor rule framework
supports the current 1% level for US interest rates. Interestingly, official
short term interest rates could even be cut below the levels seen so far, if
growth and inflation weaken further. This is instructive, as the history of the
Taylor rule set against the official actual
central bank rate shows that it has generally been a good guide to actual
rates. In addition, market interest rates are still well above the official
rate in the US, UK and euro area, see
chart a, even though they have come down in the last few days. If this is
allowed for, then it too suggests that the Fed funds rate should be 1%, in
order to get market interest rates to a level implied by the Taylor rule, based on the
traditional spread between official rates and market rates.
...in the case of the
UK, to 1Â½% in 2009, if the economy experiences a downturn as severe as in 1990,
and to zero if recession carries over into 2010
For the UK, what does the Taylor rule suggest? Chart c
shows that the rule suggested that Bank rate should be cut to 3%, though in
early 2009. But this does not take into consideration the fact that market rates
are well above the official rate. If this is taken into account, then it
suggests that UK rates should be cut to
2% in the near future. Our forecast is that rates will be cut Â½% in December to
2.5% and then in February 2009 to 2%, but it could happen sooner. They could
then stay at 2% throughout 2009. The fiscal policy response may well play a key
role in whether this becomes the actual outcome. If tax cuts and spending
increases are large enough to promote economic recovery, then Bank rate may not
be cut asaggressively as we currently expect. We have also calculated where UK rates may have to be
cut to, if the economy slips into a deep recession, see chart c. This would
open up a wide enough output gap for price inflation to turn negative, which is
a view held by some. In this case, UK interest rates would fall
to 1Â½% by mid 2009 and, if the recession persists into 2010, to zero by the end
of that year.
It looks as if interest
rates in many of the major advanced economies will fall to new lows
In the case of the eurozone, the Taylor rule suggests that the
ECB was right to cut rates to the current3.75%. However, given
market dislocation and the spread of market rates over the ECB repo rate, eurozone rates will need to come down by another 1.25 percentage points to
2.5% to get money market ratesdown to about 3Â½%.
The Taylor rule
approach highlights that there are further cuts in short term interest to come,
even though they have already been cut to historically very low levels in all
three of the economies looked at in this analysis. Another factor encouraging
cuts in nominal interest rates is that if inflation falls and interest rates
are not cut, that translates into a rise in real interest rates at a time when
the economy is in recession. To avoid this, Central banks in the advanced
economies are willing to cut interest rates to below inflation, at least in
terms of backward-looking past measures of inflation. In terms of forward looking
real interest rates, lower nominal interest rates now are still needed to
prevent too sharp a rise in future real interest rates.
After the unprecedented
rate cut by the Bank of England last week, market participants
will this week closely scrutinize the 2009 and 2010 forecasts for UK gdp growth and
inflation in the quarterly Inflation Report. The report will be published on
Wednesday. In terms of economic indicators, UK producer prices data
on Monday should show a gradual easing of pipeline inflation pressures in
October. Unemployment data on Wednesday may heighten concerns about the pace of
economic contraction and may underscore the gloomy prospects for household
spending. Retail sales and consumer confidence data will be released in the US, where President-elect
Obama may announce who will replace Mr Paulson as the next Treasury Secretary.
In the euro zone, the preliminary estimate of Q3 gdp may show that the region
slipped into recession as gdp growth contracts for a 2nd successive quarter.
â€¢ BoE governor King
famously quipped eight years ago that monetary policy should be 'boring',
referring to how a transparent central bank should lead decisions on interest
rates being predictable. The Bank was anything but that last Thursday when it
slashed interest rates by 150bps to 3.0%. The question is where does this leave
the economy, and what will happen next to Base rate? (see main article) The
reason given for the large cut was the risk that economic growth could contract
sharply and inflation would undershoot the 2% target in the medium term. Labour
market data will be published on Wednesday and are forecast to show that
companies laid off staff in October at the
fastest rate since the early 1990's. This will push up the unemployment rate
closer to 6%, a level that we suspect may be breached this winter. With more people
on the dole, spending power being eroded and credit conditions still tight for
most businesses, the risk is that the last week's rate cut may not be the last.
The worsening profile of economic activity at the start of Q4 suggests that
another quarter of contracting gdp is extremely likely in Q4. With inflation
set to fall rapidly during the course of 2009, this should keep the BoE in
'rate cutting mode' over the next few months. To this end, the Inflation Report
on Wednesday should help make it clearer whether
the Bank will keep interest rates on hold in December after making up
substantial ground last week, or whether it believes that more rate cuts are
warranted. The Report will also make clear how soon the Bank believes that
inflation will fall back to the 2% target next year - falling house prices and
lower interest rates will weigh heavily on RPI - and what the chances are of
inflation undershooting 2% in 2009 or 2010 based on implied market interest
â€¢ Focus in the US will be on retail
sales data for October and consumer confidence. Q4 is traditionally the strongest
quarter of the year for US retailers but the latest information from the labour
market and quarterly lending data suggest retailers may struggle to meet this
year's targets. Foreign trade data will be published on Thursday and are
forecast to show a decline in the deficit in October to $57.1bn due to the fall
in the value of oil imports. The Treasury will this week auction $54bn in 3
year, 10 year and 30 year benchmark paper to fund part of the Treasury rescue
package. Separately, US banks have until Friday to submit their request to
qualify for funds under the $250bn Troubled Asset Relief Programme (TARP). The
specifics of the programme and proposals of how the new administration plans to
revive economic growth through fiscal policy are likely to receive some attention
â€¢ The European Central
Bank also lowered interest rates last week, by 0.5% to 3.25%. The prospect of another
reduction in December remains intact after president Trichet said that a
further fall in interest rates 'is possible'. We believe a 0.5% reduction next
month is possible. This week's Q3 gdp and inflation data for the euro zone will
be a guide to how realistic this is. We expect gdp growth to have contracted
0.1% q/q last quarter, led by falls in business investment, household spending
and weak growth in exports. This would mark a second successive negative figure
and would officially put the economy in recession. Annual CPI is likely to have
slowed in October to 3.4%, the lowest since January.
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