Monetary Crisis … Time to consider a natural Interest Rate

I have always wondered about whether there is such a thing as a natural interest rate, interest rates have been used by countries for many things … probably the most important has been to regulate the value of its currency. The lower the interest rate the less outside funds attracted and the lower the value of its currency. In an economy where exports of goods are the main feature lowering the value of ones currency (dropping interest rates) can give a boost to an economy … however if the economy is dominated by imports it can have the opposite effect as it has the effect of pushing up prices, leaving people with less disposable income and therefore reducing demand. This can be an overall benefit to an economy as it will reduce imports and increase exports thus closing the gap in the current account balance, but this is achieved by creating a recession … reduction in demand is a recessionary condition.

Let’s return to natural interest rates.

Interest rates within an economy affect different groups of the population in different ways.

Low interest rates are most beneficial to business as they provide a way of financing increasing inventories with a relatively small impact on the cost equation, however there is only a limited level to which business can risk increased inventories in the face of a downturn … they might ultimately be forced to dump their inventories at below the cost of production. At best, low interest rates are a short term benefit to established business. They can have the effect of making new entries on the supply side … but this requires a situation where demand is strong.

To the consumer or demand side, low interest rates have a very small impact. To see this, we need to look at a mortgage bond of £100000 over 20 years. We will see that the difference in monthly payments will be approximately £80 based on mortgages at 5% and 3.5%.

If we now factor in that the drop in interest rates is likely to result in a 10% devaluation of the pound and that the UK economy is 50% import related we would see that the person with that mortgage has consumption expenditure of approximately twice as much as his mortgage repayments … alas the devaluation impact has swallowed nearly £50 of his gain, so we see very little extra disposable income … the reduction in interest rates will have a very small impact on demand.

Worse approximately 12% of the population are living off the interest generated by their lifelong savings … If I look at £200000 savings, the impact of this interest rate cut is a reduction of income of £250 per month as well as increased costs because of the devaluation impact.

Back to natural interest rates.

An economy needs to achieve several objectives; not least it must be able to generate an environment where people’s savings can provide an income or pension in later life. Actuarial studies show that with savings of 10% of income over a 45 year working life a person needs to achieve a 3% real return (in other words 3% above the inflation rate) to provide a reasonably inflation proof pension. Now, if we tax income from interest the obviously that rate is going to have to be higher than 3% above the rate of inflation, in the UK’s case let’s look at tax averaging say 30% … assuming a long term inflation rate of 2% we would be looking at an interest rate of slightly over 7% to the depositor. This would imply a Bank of England rate of about 7.5% and mortgage rates of about 8.5%.

On the other side needs the economy must create an optimum level of employment. By optimum we mean a level of employment that is not full, there must be sufficient competition in the job market to prevent wage inflation. In the UK over the last 10 years excessive wage demands have been kept in check through a large body of immigrant workers happy to work at lower rates of pay. This has allowed an interest rate policy aimed at Keynesian full employment … for the indigenous population. A non full employment policy requires a strong social security net. Do we have the will for that? We are pretty recalcitrant about the plight of the aged.

How do we reconcile these two numbers, the interest rate that has created the current level of demand and hence employment level, with the need to provide a stable environment for savings and pensions. The interest rate policy over the last 10 years has resulted in rates marginally below 5% on average, which would seem to make the two numbers irreconcilable.

We also see that our demand level is not truly sustainable as it is based on a factor we cannot control … the flow of money from the outside world.

There is no doubt that the effective devaluation of the pound that has to result from the money creation policies of Gordon Brown will go some of the way toward reducing the current account deficit, thereby reducing the dependence on borrowed money. How far, is anyone’s guess! It’s difficult to gauge the elasticity of our imports and exports to price, a large proportion of imports are food, clothing and the like while our exports tend to be high end and therefore both relatively inelastic. I think, however, that we can assume a reduction of between 25 and 33%.

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