Neutral gear
The central bank calculates the interest rate that it believes can allow these targets to be achieved simultaneously, this is known as the neutral rate of interest, or r*.
If unemployment is at 4.5 per cent or lower, and inflation is persistently above 2 per cent, then this indicates that the actual interest rate is lower than the neutral rate, so the correct response is to tighten rates to drive inflation down. If unemployment is much higher than 4.5 per cent, and inflation is above 2 per cent or so, then this indicates the prevailing interest rate is too high, and so a rate cut is due.
In the UK right now, unemployment is precisely 4.5 per cent, but inflation is around 5 per cent, or more than twice the target. On that reading, the present base rate is too low relative to r*, and the recent rate rise is justified.
Lyons says: “In reality, interest rates and monetary policy were set for emergency conditions at the start of the pandemic, and the emergency, in economic terms, has ended, so rates needed to be higher.”
The pain element referred to by Bartholomew, is that by putting rates up to deal with higher inflation, there is an increased chance that the unemployment number rises. This is what happened when policymakers in the 1980s set about reducing the lingering inflation from the oil price supply shock.
He says that by talking about rate rises, central banks can have the effect of a rate rise, without actually having to act.
Lyons says that the neutral rate of interest in the UK and globally may be structurally lower now than has ever previously been the case as a result of high debt levels, ageing populations and technological change, all of which are likely to keep inflation lower over the long term.
He adds: "Factors such as ageing populations and high debt levels and technological adoption were there before the pandemic and they have not gone away."
For clients, advisers and households, that means it should take less in the way of interest rate rises to dampen inflation in future, and that the definition of 'high' inflation will be a lower rate than was the case in the past, meaning interest rates should also be lower than previous peaks, even if it is higher than now.
In that scenario, over the long term interest rates and inflation would be low, relative to history.
But Bartholomew says the same affects that could lead to structurally lower interest rates are also likely to mean structurally lower levels of economic growth, and a scenario where the amount of GDP growth required to cause inflation will be lower, so while interest rates and inflation rates may peak at much lower levels in the UK than historically, there could also be more volatility, with rates rising and being cut more frequently than has been the case over the past decade.
