Err, Anatole?

Thursday\’s quarter-point rate cut, to 5.25 per cent, left British interest rates more than a full percentage point above the level prevailing in every leading economy apart from Australia.

Come along now, that\’s an irrelevance. We don\’t care what nominal interest rates are, only real. What\’s the number after we adjust for inflation? From memory (and using RPI not CPI) UK rates are now something like 0.5%, maybe 0.75%.

17 thoughts on “Ouch”

  1. Sorry Tim but I have never heard of this before – can you elaborate?

    Tim adds: The interest rate is 5.25%. OK. Inflation is what, 4.5/4.6%?

    Right, so if I borrow £100 today to pay back in one year’s time, I will pay back £105.25 in actual cash (which is what we call nominal). Yes?

    But because of inflation, the £100 I got to day actually is only worth, in terms of the things it can buy, £95.50 in one year’s time? Yes?

    So the actual interest (what we call the real interest) that I’m paying back is about 75p. Or about 0.75%.

    The way to calculate this is to take the interest rate you’re told, subtract from it inflation, and this gives you the real interest rate.

    We can get a lot more complicated (there’s something called the “money illusion” where people think they’re getting richer because they get more money, but after inflation they’re actually getting the same amount) but that’s the essential point of it.

    It really becomes important when those real interest rates become negative: if, like they have been in the US, interest rates were below the inflation rate. This is like someone paying you to borrow money and usually leads to a bubble in asset prices: as indeed we’ve seen.

    Another way to think of this. If inflation is 5% and your pay rise is 10%, then yes, you’ve got a pay rise: 10% in nominal terms, only 5% in real terms. If you’re the UK police this year and inflation is 4.5% and your pay rise is 2.9%….well, you’ve had a pay rise in nominal terms and a pay cut in real terms.

  2. I would strongly suggest nominal rates aren’t irrelevant. Not everyone gets inflation-adjusted income, so there will be distributional effects at the very least.

  3. If inflation is that high then surely interest rates should be raised!

    After all, the credit crunch can only be fixed by people actually saving more and thus lending the banks more to invest on their behalf.

  4. It’s also pretty doutbful that RPI is the best measure of real interest rates in this context (given that the most important difference between RPI and CPI is mortgage spend, which is dependent on interest rates anyway…)

  5. In today’s news:

    “Price inflation of goods leaving UK factories has reached its highest rate in 16 years, driven higher by petrol and food costs, official figures show. Annual output price inflation reached 5.7% in January, up from 5% the previous month, according to the Office for National Statistics (ONS).”

    Producer prices often tend to be consumer prices in the pipeline.

    Besides that, another good reason why interest rates need to be relatively high in Britain is because of the continuing budget deficit, amounting to 3.2 per cent of national GDP – as compared with 1.7 per cent in America or 2.8 per cent in France, where the respective sizes of budget deficits are already issues.

    The UK’s Institute of Fiscal Studies recently called for a tax hike of £8bn to close the hole in national finances:

  6. “It’s also pretty doutbful that RPI is the best measure of real interest rates in this context”: I’ll bet it’s not the best, but it’s a darn sight nearer to the inflation rate that I seem to experience than is CPI. And my mortgage outgoings are now tiny, I’m glad to say.

  7. Conor:

    Tim’s explanation is quite correct as far as it goes. But the fact that you hadn’t appreciated what Tim explained tells me that you also don’t appreciate its significance.

    Interest rates are numerically-expressed composite opinions about the relative importance of consumption available now or at some period in the future. They are important because they reveal, to everyone, just what such opinion is on the part of everyone else.

    As an example, when interest rates seem “high,” it is virtually the same as saying that people are tending to prefer greater consumption in the present, which has the effect of raising the prices of such things (and, conversely, of depressing those of things which cannot provide satisfaction until time has passed).

    Under any prevailing state (of interest rates) people are guided into certain patterns of economic activity; it is immaterial whether we say that the pattern of behavior is expressed in the rate or that the rate is expressed in the pattern. They are the same thing in different words. In a taste test, one may certainly prefer tenderloin to chuck; in choosing in the market, however, one’s preference will be duly modified by relative prices. Thus, lower interest rates shout: ” you’re richer! We’re all richer! Times ain’t bad–and they’re getting better! Things now are less expensive and the future’s looking even brighter!”

    That optimistic message, expressed as a number, has less significance for ordinary consumers than observation of everyday prices. But it is of paramount importance for the businessman and the investor. The rates appear as prospective costs in the planning of businessmen–determinants of losses in some cases, or of profits and their rates in others. The difference between “No” and “Yes” to building and expansion plans, to determination of just which lines in research and development, and to guiding both employment and its compensation policies. It is the difference between selling just what you’ve got, expectating tomorrow to be like today and yesterday or gearing up–not to miss out on tomorrow’s demands. It’s the difference in disposition of assets and of liabilities.

    Tinkering with interest rates (“management of the money supply”) induces mistakes; most can be changed almost invisibly and are: a less expensive or shorter holiday, dining out less frequently, forget a new kitchen. Business lays off the recent hire, doesn’t open a new granch, sells off the second delivery truck, etc.

    Some mistakes by business can be corrected–liquidated–easily. But a fair number are less amenable and appear as mistakes currently unremedifiable. A store closed for whom no new tenant may be found; machinery for whose product there is no market (and whose very presence interferes even with attempts to sell the land). Homes and neighborhoods have been established just on account of expansion previously undergone–in places where few other employment opportunities exist. Though relatively few in number, there are even some (such as large mining operations) where expansions have actually involved assemblage of an extraordinary mix of occupational specialities from great distance as well as the expenditure of huge amounts on equipment. Just the decision to liquidate or not is enormous and may often opt to continue at some loss-minimizing level just to keep the operation ready should conditions improve. The point is that, though mistakes are correctible, the physical embodiments–the idled men and particularly the useless plants, equipment , and all wasted labor and management time–represent not only losses to business men but an irreparable diminution in the welfare of everyone.

  8. Thanks Tim – I should have been more explicit (and I didn’t mean to be so curt in my question!).

    Instinctively I get the nominal interest rate thing it is just more that inflation (RPI/CPI whatever) is a snapshot and somewhat abstract measure (illustrated by the fact that their are a varieties of it that differ significantly). Your implication is that it is nominal inflation (if thats the correct term) that matters (and that makes sense) but why do we not hear more about it when comparing economies etc?

    Just trying to improve my economic literacy!

    Thanks for your response.

  9. The GDP deflator has been running at just under 3%, so that’s about as comprehensive as you’ll get (unless you think GDP is miscalculated, which is not impossible).

    Bob – can you elaborate on your point? When the US budget deficit was well over 3% GDP interest rates were 1%. Is there an obvious connection between short-term interest rates and the budget deficit?

  10. “Is there an obvious connection between short-term interest rates and the budget deficit?”

    Short-term interest rates are set by the Monetary Policy Committee (often shortened to: MPC) of the Bank of England to maintain a specified inflation rate at a constant rate as best it can. The inflation rate specified by statute is 2 per cent, as measured by the Consumer Price Index (CPI), which happens to exclude house prices, an issue of some significance in this context with the extent of the bubble in house prices in Britain [1].

    The effect of raising (lowering) interest rates is to curb (promote) the growth of aggregate monetary demand for up to some two years downstream. Raising (cutting) income tax rates will also curb (stimulate) the growth of aggregate monetary demand, usually with more immediate effect – depending on which tax rates are changed – and that would make it less necessary to change interest rates to curb (or promote) the growth in aggregate demand.

    Short term interest rates are relatively high in Britain because Gordon Brown, as Chancellor, adopted a relaxed fiscal stance by maintaining a continuing and relatively large budgetary deficit – and a deficit, incidentally, that ignors off-balance sheet items like Private Finance Initiative (PFI) items where investments in public services projects are financed by private money in exchange for long term contractual payments made out of public expenditure.

    A lower budget deficit would have made it less necessary for the Bank of England to raise short term interest rates to present levels.

    [1] The extraordinary extent of house price inflation in Britain, compared with other major economies, can be judged from the graph in this issue of The Economist last May:

    Arguably, given the size of the continuing budget deficits, short term interest rates should have been set higher to avert the house price bubble. The fact of the bubble indicates a major policy failure even if house price bubbles are hugely popular with house owners.

  11. I’m not convinced. Japanese interest rates were near 0% when the country had a budget deficit approaching 10%.

    If you’re only saying that interest rates need to be higher because aggregate demand is too high, and it is too high partly because fiscal policy is too loose, then what you’re really saying is:

    Interest rates are high because the economy is expanding robustly.

  12. “Japanese interest rates were near 0% when the country had a budget deficit approaching 10%.”

    Comparisons with the British are altogether misleading. Conditions in Japan’s economy have been so different from those prevailing here that no lessons can be drawn regarding Britain’s extraordinarily large budget deficit in an economy close to a business cycle peak and with employment running at record levels. Nor does the example of Japan help to illuminate Britain’s house price bubble.

    Until the last few years, Japan’s economy has been virtually stagnant since 1992, with little or no growth in real GDP from year to year and with consumer prices FALLING on trend for much of the period.

    It that context, it was rational for consumers there to postpone buying anything that wasn’t absolutely essential because it would be cheaper to buy it in a year’s time.

    The central bank cut interest rates to virtually zero so as to boost consumer spending and business investment but without much success, it must be admitted. The government ran up a large increase in Japan’s national debt by borrowing, rather than taxing, to fund increased public spending in order to boost aggregate monetary demand and so curb the rate of price deflation. The government was obliged to make successive attempts to stimulate the economy but had little success and price deflation persisted for years. At present, consumer price inflation is almost zero there, unlike Britain.

    Perhaps the most that can be said on behalf of Japan’s monetary and fiscal policies was that the state of its economy would have been even worse without the policy interventions.

    Apologies for delay in responding but my ISP was having problems and its helpline was inundated.

  13. But I still don’t understand your point. Am I right in saying it is:

    Britain has high interest rates because its economy has been growing robustly (and a part of a reason for that is loose fiscal policy)

    or are you saying there is something about that growth that requires high interest rates and that something has been caused by loose fiscal policy?

    Also Britain doesn’t have an ‘extraordinarily’ high budget deficit, even given the position in the cycle.

  14. “Britain has high interest rates because its economy has been growing robustly (and a part of a reason for that is loose fiscal policy)”

    Britain has relatively high interest rates because the government has elected to maintain a loose fiscal stance with a relatively large budgetary deficit notwithstanding employment at record levels and the UK economy being near a business cycle peak – and with a deficit that would be even larger were the off-balance sheet public sector investments funded by PFI to be taken into account [1].

    That diagnosis is hardly eccentric given the recent assessment of the Institute of Fiscal Studies that the government needs to hike taxes by £8bn to maintain its own fiscal rules – see link above. With a more stringent fiscal policy, the MPC of the Bank of England would have been under less pressure to raise short-term interest rates to curb inflation. The government effectively opted for a combination of a more stringent monetary policy with a softer fiscal stance, apparently in the belief that the combination would have greater electoral appeal.

    Besides that, you favoured Britain joining the Eurozone yet the EU Commission is presently admonishing France for the size of its budget deficit, which is smaller than Britain’s as a percentage of national GDP:

    “(BRUSSELS) – France came under fire on Monday from its eurozone partners for not doing more to cut its budget deficit as Paris sought more leeway on improving its finances in the face of weakening growth.”

    [1] By this report, the NHS has signed up to PFI (Private Finance Initiative) deals worth a total of £53 billions, of which only £8 billions relate to the construction of new hospital buildings. Ministers seem to be a bit coy about what the other £45 billions relate to but, broadly speaking, that seems to be for building design and maintenance.

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