As Mark Carney prepares to make way for new governor Andrew Bailey, he’s voiced the suggestion that UK interest rates could be cut if the economy wobbles in early 2020.
His view may be in anticipation, as some have concluded, of an economic shock resulting from the UK’s exit from the UK on 31st January. However, with an 11-month transition phase delaying the effects, it is perhaps more likely that his comment reflects the fall in price inflation and growth.
Price inflation fell to just 1.3% in December, from 1.5% in November. In addition, retail sales growth dropped by 0.6% in December, marking a decline of 1% in volume terms in the quarter to December 2019 – the worst performance for retail sales since 2012. With monthly GDP data suggesting that the economy contracted by 0.3% in November, the implication is that Q4 2019 was a period of economic stagnation, with annual GDP growth averaging just a little over 1%.
The November, December and January meetings of the MPC voted 7 to 2 to hold rates; the two members voting for a cut were the same on each occasion. It was a similar state of affairs at the IEA’s Shadow MPC meeting in January, with the vote 6 to 3 in favour of a hold. In this case, however, the three dissenting members voted for an increase. Their arguments? Firstly that UK labour market data shows the economy at full employment and real pay rising. Secondly, that political uncertainty has eased in the wake of the General Election and a firmer Brexit timetable, and finally, that the sustained period of low interest rates has promoted unproductive investment, leading to low productivity and weak growth.
Is monetary policy already loose enough?
Certainly, looking at the data, there’s a strong argument against a rate cut in 2020. Monetary policy is already very loose. Real interest rates – the nominal Bank rate deflated by consumer price inflation – are -0.5%. Consumer borrowing in the year to November 19 was up by 5.7% (although 9.4% at its peak in July 18) and broad money supply growth has also slowed. These are clear signs that the boost to borrowing is waning. Indeed, whilst price inflation sits well below the Bank’s 2% medium-term target, and annual GDP growth hovers around 1%, making a rise in interest rates unlikely any time soon, there will ultimately be a reversal.
When is uncertain. However, strengthening economic growth and inflation trends will be key determinants. If we look at historic trends, we can see (Chart 1) that since the 1950s, price inflation and interest rates have moved closer. Three decades of interest rates remaining well above inflation (in the 50s, 60,s and 70s) finally secured the prize of low inflation. With that achieved, the last decade has seen interest rates below inflation, creating negative real interest rates.
What Chart 2 shows, is that despite declining low real interest rates, real GDP growth also fell back over the past 50 years – turning the assumption that lower real interest rates would lead to faster GDP growth on its head. What we’re actually seeing is that, from a growth rate averaging 4% on an annual basis in the 1950s, GDP growth has slowed in every subsequent decade.
It’s notable that the persistence of negative interest rates since 2009, amidst weak economic growth in the decade, has led some to argue that negative rates are damaging the economy’s performance. Unproductive investment, the argument goes, is leading to weak growth because it damages productivity. Our data, however, stretches back 70 years, and shows that growth was slowing even when real interest rates were positive – i.e. above inflation. Therefore, in my view, other factors are at play.
Notwithstanding these trends, the pattern of low real and nominal interest rates and low inflation that’s characterised the UK over the last 20 years is unlikely to change unless something dramatic occurs. For 2020, therefore, despite a calendar filled with political and economic events, low interest rates and low inflation look set to persist.
What’s more, if the UK does continue to experience negative interest rates, low inflation and weak growth, it will mean that public spending pledges, designed to level up growth across the UK’s nations and regions, will be met from higher levels of debt as a share of the economy rather than paid out of faster growth.