What is the Normal Rate of Interest?

Monetary policy involves the setting of policy objectives and achieving policy objectives. In the UK, the Bank of England sets the monetary policy objective which is to maintain price stability. The government provides an operational definition of price stability. This has been specified as a target rate of inflation of 2% per year. Although this target is renewed every year, the intention is to lock-in inflation at a low and stable rate over a long period so that expectations of future inflation is stable at around 2%. This is important because so many economic variables are dependent on expectations of future inflation, such as interest rates, earnings growth, and the exchange rate. But also stable inflation makes it easier for firms and households to make decisions about investment and savings that brings sustainable long-term economic growth.

Price stability is the key goal of monetary policy but the government also keeps an eye on growth and employment. In the short-run, the Bank of England faces a trade-off between inflation and economic growth and employment. Taking action that is designed to lower the inflation rate could mean slowing the economic growth rate and lowering employment.

The action the Bank of England takes is on the Bank Base Rate. As the recession following the Global Financial Crisis took hold, the Bank Rate was lowered sharply to ½% and has stayed there even though the economy had returned to its maximum capacity by 2015. Why doesn’t the Bank of England restore interest rates to what it was before the recession? Is ½% the new ‘normal’ rate? To understand what the normal rate is, we need to subtract inflation from the rate of interest to reveal what is known as the ‘real’ rate of interest.

In March 2009 the Bank of England launched its programme of Quantitative Easing or QE. The purpose of QE is to make the commercial banks and other financial institutions flush with cash and increase the demand for bonds and other financial assets. This way, the Bank of England not only reacts with a cut in the Bank rate but also uses QE to lower the long-term rate of interest. QE has been partially successful. After the initial crash in share prices following the Global Financial Crisis, share prices did indeed recover. But what about long-term interest rates? Long-term interest rates did indeed fall and they kept on falling.

Many argue that keeping interest rates so low has created extra risk as investors have searched for yield and the extra stimulus from QE has inflated asset prices. A rise in bank rate and the reversal of QE will see asset prices falling and long-term interest rates rising. Indeed this will cause some pain to asset holders who believe that long-term interest rates will continue to remain low for the foreseeable future. The Federal Reserve in the USA has signalled a return to normality and the reversal of QE. Some £445 billion of UK government and corporate assets will have to be disposed of by the Bank of England and about $4 trillion by the Federal Reserve in the USA. A precipitous sale of these assets could cause a market crash and a loss of confidence. The members of the Shadow Monetary Policy Committee of the Institute of Economic Affairs have consistently recommended that QE be reversed in stages and the Bank Rate be raised in steps of 25 bps to reach a normal rate of interest.