Why UK interest rates could stay lower for longer than you think

Marcus Wright

RBS Economics (@RBS_Economics)

August 2015

Slide 2Source: Bloomberg, Macrobond

Of the OECD central banks that raised rates after 2008, all have either lowered or begun to lower them again

Turkey (Jan-14)Denmark (Apr-11)Eurozone (Apr-11)

N. Zealand (Jun-10)N.Zealand (Mar-14)

Sweden (Jul-10)Chile (Jun-10)

Hungary (Nov-10)Poland (Jan-11)

Korea (Jul-10)Australia (Oct-09)

Israel (Aug-09)Norway (Nov-09)

Iceland (Sep-11)Canada (Jun-10)

477

915

1719

2122

24252526

3855

Number of months from 1st rate hike to first rate cut

What this is about• Markets expect the Bank of England to start raising rates from

early next year. In 3 years Bank Rate is expected to be 1.5%. While possible, it is not inevitable. We’ve seen these sorts of expectations dashed before.

• The following slides set out the economic case for ‘lower for longer’ interest rates in the UK.

• ‘Lower for longer’ doesn’t necessarily mean interest rates cannot go up. It can also mean central banks trying to raise rates a little, before seeing them forced back down soon after.

Source: BIS

UK inflation is determined globally – part 1

• Long term inflation expectations are firmly on target around the world. This means less need for interest rate hikes, since inflation is currently low.

• Things that drive price inflation are now more responsive to global factors. For example, earnings growth has become increasingly correlated across economies.

0

1

2

3

4

5

6

7 Inflation Expectations Against Target (%)Long-term inflation

expectations

Target

CH JP EA CA CZ NZ GB SE US PL NO KR PE AU HU TH CN CL CO MX PH BR RU ID IN TR

0

10

20

30

40

50

60

1996-2000 2003-07 2010-14

Correlation of Cross-Country* Wage Growth (%)

# - AU,CA,CZ,EA,HU,JP,KO,NO,PO,SA,SW,SZ,UK,US

Source: Macrobond, ONS, Bloomberg, International Federation of Robotics

• The slowdown in UK real earnings growth pre-dates the financial crisis.

• Net migration, outsourcing, offshoring and labour-saving technology have kept a lid on wage growth.

• Capped wage growth reduces the likelihood of inflation picking up too fast or too far. 0

50

100

150

200

250

300

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 15-'17 F-cast

Worldwide Sales of Industrial Robots (000s)

UK inflation is determined globally – part 2

Source: Macrobond, Bloomberg

China is a big deflationary force for the world…

• Chinese export price inflation explains a lot of what’s going on at the moment

• Cheap goods from China were a key factor in the pre-crisis world of low inflation, low interest rates and increased risk-taking. They still are.

• China’s slowdown has so far led to a drop in oil and raw materials prices and a world trade recession. Both mean less inflation for us.

0

10

20

30

40

50

60

70

1971-85 1986-98 1999-2013

Causes of Inflation Variability in Advanced Economies (%)

Inflation variability caused by the same common factorInflation variability caused by Chinese export prices

Source: Macrobond, Bloomberg, Bank of England, Bank for International Settlements

…and it’s only going to continue as money continues to flow out

• China’s banks are sitting on £10trn worth of deposits. As China liberalises its financial system these savings will flow out of the country in search of returns.

• Capital outflows will put further pressure on the currency. If China lets its currency float it would make its exports cheaper and lead to even lower prices across the world.

-

2

4

6

8

10

China UK

Banking Sector Deposits (£ trn)Households and Non-Financial Corporates

-30 -20 -10 0 10 20 30 40

ChinaBrazil

RussiaIndia

PolandIndonesia

MexicoSouth Africa

Malaysia

EM Currencies - Under/Over-Valuation Estimate

(Real Effective Exchange Rate)

Increasingly'under-valued'

Increasingly'over-valued'

Source: IMF, Macrobond, Bloomberg

The global savings glut – it’s still there

• ‘Global imbalances’ matter. The wall of savings moving from ‘surplus’ countries to ‘deficit’ countries is helping to keep interest rates low in the latter (e.g. the US and the UK).

• And there’s more to come. Global savings are higher than before the crisis. Emerging Asia in particular and will have high savings in the coming years.

101520253035404550

1980 1984 1988 1992 1996 2000 2004 2008 2012 2016 2020

Savings Ratios (% of GDP)

Global Global Forecast G7

G7 F-cast Emerging Asia Emerging Asia F-cast

-1,000

-500

0

500

1,000

1,50020

03

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

Global Imbalances(Currenc Account Positions $Bn)

Australia

Spain

UK

US

Japan

Germany

China

Oil Producers

Source: Financial Stability Board, Macrobond, Bloomberg

Quantitative easing is going to continue in Europe and Japan

• Central banks are also keeping rates down by buying up government bonds (Quantitative Easing or QE).

• While QE may have come to an end in the US and the UK, the European Central Bank will be carrying on until Autumn 2016, while the Bank of Japan’s programme is open-ended.

020406080

100120140160180200

2009 2010 2011 2012 2013 2014 2015

Central bank purchases ($Bn)

Fed Bank of EnglandBank of Japan Bank of Japan Forecast PurchasesECB ECB Foreast Purchases

-2

-1

0

1

2

3

4

Banks Ins. Comps & Pens.Funds

Public FIs Non-Bank FIs Central banks

Change in share of financial assets 2007 - 2013 (percentage points)

Source: Macrobond, Bloomberg

Domestic reasons for low rates – part 1

1

1.5

2

2.5

3

3.5

4

4.5

1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 -2015

UK Services Inflation - % Y/Y

• Core inflation (which excludes food & fuel) has been decreasing for four years. And lower inflation is not just about oil prices and a stronger currency.

• Services inflation has dropped well below the 3 – 4% it has averaged for close to 20 years. It is now averaging 2 – 3%.

0.5

1.0

1.5

2.0

2.5

3.0

3.5

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

UK Core Inflation (i.e. excluding food, energy and other volatile items) % Y/Y

Source: Conference Board, Bank for International Settlements, Macrobond

• The UK’s productivity growth following the crisis has been exceptionally poor. There is no single explanation as to why, but the problem is deep-rooted.

• Without productivity growth wage growth and economic growth could easily fizzle out. That means low inflation. And low interest rates.

-6%-4%-2%0%2%4%6%8%

10%12%14%

Gre

ece

UK

Finl

and

Italy

Belg

ium

Net

herla

nds

Nor

way

Cypr

usSw

itzer

land

Ger

man

ySw

eden

Denm

ark

Aust

riaFr

ance

Turk

eyM

alta

Icel

and

Luxe

mbo

urg

Port

ugal

Spai

nIre

land

Labour Productivity Growth 2008 - 2014 (Output per hour)

Domestic reasons for low rates – part 2

-2

3

8

13

18

-2

3

8

13

18UK - Wage Growth v Productivity Growth

(% Y/Y Change)

Nominal Wage Growth

Productivity Growth

Source: Macrobond, Bloomberg, Office for Budget Responsibility

• There are substantial cuts in public spending to come. For the government to attain a budget surplus it is likely that the private sector will have to start borrowing again. That is rarely sustainable for long.

• It’s likely that for austerity to succeed without causing a recession, the Bank of England will have to keep rates low. Simultaneous fiscal and monetary policy tightening normally only achieves this when exports are growing strongly. And they aren’t.

-4

-2

0

2

4

6

8

10

1997 2000 2003 2006 2009 2012 2015 2018

Private Sector Financial Balance in the UK (% of GDP)

PNFCs Forecast PNFCsHousehold Forecast HouseholdsTotal Private Sector

-12

-10

-8

-6

-4

-2

0

2

2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020

UK Budget Balance(% of GDP)

Historical Data

IMF Forecast

OBR Forecast

Domestic reasons for low rates – part 3

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