Are higher interest rates a necessary evil?

“An economist is an expert who will know tomorrow why the things he predicted yesterday didn’t happen today.” Laurence J. Peter

When I was studying economics at university (not that long ago) I was taught under ‘neo-classical’ thinking, which had come to pre-eminence in response to the period of ‘stagflation’ in the 1970s. Under stagflation both unemployment and inflation were stubbornly high, which naturally proved a significant drag on living standards. Although likely not solely to blame for the issues of the time, inflation was identified as the main problem, and controlling it the key to ensuring stable economic growth.

In the UK Margaret Thatcher pursued ‘monetarist’ policies – designed at controlling the flow of money and thus inflation. In the US Ronald Regan’s policies were similar, which lead to the coining of the term ‘Reaganomics’. Inflation was to be attacked through high interest rates, with ‘supply side reforms’ employed to also help reduce inflation while encouraging growth. Some of these reforms, such as curbing the power of unions, were designed to make the workforce more flexible (or easier to fire, depending on your view). There was also a liberalisation of financial markets which would provide cheaper capital, and privatisation of various public services, intended to drive productivity.

To this day central banks have controlling inflation as their prime objective, although the US Federal Reserve does also aim to reduce unemployment to the point it doesn’t cause rising inflation. Following the Global Financial Crisis (GFC) central banks have also tended to keep an eye on ‘financial stability’ (although what that means is highly debateable). Essentially as long as inflation is controlled they are free to pursue growth policies, but inflation concerns come first. Indeed the Governor of the Bank of England must write a letter to the Chancellor if inflation breaches 3%.

The problem with economic theories is that they tend to be very good at predicting economic behaviour, until they aren’t. By controlling inflation, monetary policy was supposed to reduce booms and busts in the economic cycle and provide strong, stable economic growth. This seemed to be working to theory, until following a period of strong growth with low inflation in the mid-2000s, we experienced the GFC. Further, in the years since, inflation has barely flickered, and we are only just experiencing any sort of pick-up in growth, despite aggressively low interest rates and unconventional monetary policy which in effect reduced interest rates below 0%.

Given the recent failings of neo-classical theory, many are now calling for a rethink. One area that could really come under review is the fact that interest rates have been continually falling since the early 1980s. There have been many theories posited as to why, such as:

• central banks being overly successful in controlling inflation, so less inclined to raise interest rates
• globalisation being inherently disinflationary
• ageing demographics slowing growth, so reducing demand
• falling productivity growth.

The Bank of International Settlements recently released a paper titled ‘Monetary policy in the grip of a pincer movement’. In it they raised the issue that persistently low interest rates can cause a perpetual cycle of growing financial instability by causing booms in credit, which encourage uneconomic investments, especially in construction, and eventually a financial crisis. These uneconomic investments combined with more highly leveraged economies then become a drag on future growth, cause even greater financial booms and busts, which central banks respond to by reducing interest rates further. They argue that central banks trying to find economic equilibrium (essentially stability) by setting interest rates solely to control inflation, while ignoring financial instability from increased levels of credit and asset prices, are missing the bigger picture.

In short, although they prescribe a list of remedies that might help, they are calling for persistently higher interest rates, as opposed to neo-classical theory that prescribes higher interest rates only if inflation needs controlling. However whether this remedy is even possible given levels of debt around the world is highly doubtful, with many economists predicting that the Fed will be unable to hike rates beyond c.3.5% for fear of sparking a recession through heightened defaults.

Yet even with enormous global debt levels, arguments for increased rates may be finding their way into central bank policy. Jay Powell, the new Fed Chair (not included on the above, highly accurate graph), has said he thinks a rules based interest rate mechanism may be helpful. By rules based, many assume he is referring to the Taylor Rule, which proscribes a certain level of interest rates in response to changes in inflation, output, or other economic conditions. In particular, the rule stipulates that for each 1% increase in inflation, the central bank should raise the nominal interest rate by more than 1%. Although the focus is still on inflation, if these rules were currently in force interest rates would be significantly higher. What is perhaps surprising is that Jay Powell was named Fed Chair by Donald Trump, who has been promoting an America first, jobs first policy, which would almost certainly in the short term benefit from interest rates remaining low through continued cheap borrowing and a weaker US Dollar. Mind you who knows, on recent evidence he may be fired by tweet within a year.

We are already underweight fixed income as global interest rates finally appear to be climbing from historical lows, which have made bonds very expensive relative to other asset classes. But if these more hawkish theories were to have greater sway over central bank policies we should expect to see higher interest rates over the long term (assuming they don’t themselves cause a financial crash), which would be even worse for fixed income, especially long duration instruments.

So what economic theory has come to pre-eminence in university teaching now? I don’t actually know and would be keen to find out, but I bet its predictions will be wrong.