What caught my eye this week.
The Bank of England is hellbent on crashing the economy, having recklessly raised interest rates by 0.25% to 0.75% this week.
No, that’s not my opinion. But it was a view sounded by many commentators in the wake of Bank Rate rising above 0.5% for the first time in a decade. Critics even included one former Bank Rate setter.
Really? Let’s remember that with inflation running at well over 2%, we still have a strongly negative real interest rate. (‘Real’ means inflation-adjusted, remember).
In real terms, even after this latest rise Bank Rate is still MINUS 1.55%.
And that’s before we take into account the impact of all those rounds of quantitative easing, the point of which was to effectively lower real interest rates in the market.
Money remains historically very cheap.
Borrowers still blessed
It’s true that several million people on variable rate, tracker, and discount mortgages will see their monthly payments inch up a tad.
But many such homeowners have seen their mortgages being paid off by a decade of negative interest rates. For all the austerity felt by the poor, it’s been a super time to be a middle-class homeowner. Few should complain too loudly about a 0.25% rate rise.
On the flip side, some of the rate rise will be passed on to savers, though as we slowly return to something like normal rates we should expect this to lag.
UK banks never took the interest rates paid to ordinary savers below 0% in the financial crisis. Instead there was a compression of the spread of rates that banks usually profit from. This will have to be unwound, and so I expect savings rates to rise more slowly than mortgage rates.
Personally, I’m inclined to think that if the economy cannot take a slightly less negative real interest rate – fully ten years after the financial crisis and with employment and with house prices at an all-time high – than we ought to find out sooner rather than later, as opposed to speculating.
With the rate rise expected by everyone, perhaps the more interesting thing to come out of the Bank was an estimate what its wonks call r*. (Pronounced “r-star”).
r* is shorthand for the ‘equilibrium real interest rate’ – and if you think that mouthful is reason enough for the shorthand, wait until you hear the long definition:
The ‘equilibrium interest rate’ is the interest rate that, if the economy starts from a position with no output gap and inflation at the target, would sustain output at potential and inflation at the target.
Okay, perhaps that’s not too confusing. But then I have been reading the Bank’s deliberations for the past couple of hours, so perhaps I’m inured to banker-speak.
You can get up-to-speed on r* for yourself by reading pages 39-43 of the newly-published Inflation Report [PDF].
Basically r* is the Goldilocks interest rate – neither too hot (that is, a rate that’s too low) to stoke the economy and push up inflation, nor too cold (er, a rate that’s too temptingly high) to incentivize savers to move their money out to work fueling the engines of capitalism, as opposed to leaving it all sitting in a bank in cash.
Unfortunately, there’s no way of knowing exactly what r* is at any particular time.
Instead, policymakers have to infer it, in the same way that you have to try to figure out if he or she is really in love with you.
Various factors may weigh down – or boost – the equilibrium real interest rate. In the medium to long-term though there’s presumed to be an underlying trend rate – confusingly also called R*, though note the capital – which is where real interest rates could sit if the economy never fluctuated and Bank officials could spend their time at the beach instead.
Sadly in the real world, things do impact the rate – an impact that the Bank labels s* (where the ‘s’ supposedly stands for short-term but which I think stands for
shit stuff happens.)
When s* would heat things up, r* would need to be higher than it otherwise would be (R*).
When s* is a drag, r* would need to be lower.
Right now the Bank believes we’re still in a sticky patch for ‘stuff happening’, what with the Brexit uncertainty, talk of trade wars, the lingering impact of the financial crisis, and also perhaps rates around the developed world being similarly measly.
This belief that r* is low is why Carney and Co. have been keeping Bank Rate so low, and why the Bank is raising rates so slowly.
The Bank’s assessment is that R* would be too high a Bank Rate to keep inflation on target at 2%, given the headwinds.
It believes r* is lower, and hence we still get low interest rates.
R-stars in their eyes
If you’re not asleep by now, no doubt you’re screaming: “Great, but what should R* be! Surely that’s the important bit!”
You’re right, like the Bank of England I’ve deliberately buried the lead.
After stressing that its best guess is just that, the Bank estimates that R* – the long-term trend real equilibrium rate, you’ll recall – is currently somewhere between 0%-1%.
What’s more, it estimates R* has plunged from around 2.25%-3.25% back in 1990!
This is all hugely significant.
Remember, R* is a real interest rate. Add the 2% inflation target onto it, and we get to where the Bank Rate would be in a perfect world (to over-simplify).
What the Bank is estimating is that absent those short-term / stuff happens factors, Bank Rate would now be at between 2-3% (as opposed to 0.75%).
In contrast, if R* was still where it was in 1990, the equivalent ‘normal’ Bank Rate would be 4.25-5.25%.
Clearly this has big implications for both savers and borrowers.
It suggests anyone waiting to get 5% – or even 3% – in a standard savings account shouldn’t hold their breath.
Similarly, mortgage holders shouldn’t have too many sleepless nights worrying about rates leaping back up to 5-7%, at least on current forecasts.
Playing for ratings
Of course if R* can come down then it can go up again.
The Bank thinks that the aging population, slower productivity growth, and the impact of more cautious financial regulation has likely pulled down R*.
Set against that, it believes the requirements of younger foreign savers and even the rise of the robots could affect R* in the future.
But it doesn’t expect anything to happen very quickly, to either r* or R*.
Absent some huge shock such as a Hard Brexit or a surprise election-related run on the pound, the bottom line is interest rates aren’t going much higher anytime soon.
How to open an online broker account and start investing – Monevator
From the archive-ator: They don’t tax free time – Monevator
Note: Some links are Google search results – in PC/desktop view you can click to read the piece without being a paid subscriber. Try privacy/incognito mode to avoid cookies. Consider subscribing if you read them a lot!1
Bank of England raises UK interest rate to 0.75% – BBC
Five things we learned from the Bank of England’s deliberations – BBC
UK house prices hit new record average high of £217,000 – ThisIsMoney
Job-switching workers enjoy fastest pay growth in a decade – Guardian
Inheritance tax hits record high: What are the thresholds? – The Week
Interesting series of graphs show how America divvies up its land – Bloomberg
Products and services
It’s happened: Fidelity unveils the first no-fee index funds (in US) – Investment Week
Yorkshire Building Society offers 10-year mortgage fix at just 2.49% – ThisIsMoney
Savings banks and mortgage lenders react to the rate rise [Search result] – FT
Got £1,000 spare? Ratesetter will pay you £100 [and me a cash bonus] if you invest it with them for a year – Ratesetter
George Soros-backed firm unveils superfast broadband rollout in UK – Guardian
Online shoppers to face extra security check, via smartphone [Search result] – FT
What to do if HMRC makes a so-called emergency tax raid on your pension cash – ThisIsMoney
Comment and opinion
Charley Ellis: Indexing and its alternatives [Podcast] – Capital Allocators
Willing losers – A Wealth of Common Sense
Four lessons from the richest woman in Wall Street history – Of Dollars and Data
The (other) problem with active fund management – Behavioral Investment
How to make your child a pension millionaire by 43 – ThisIsMoney
Why even winning investors and tennis stars often feel like they’re losing – The Value Perspective
Last Chance U and financial independence – Young FI Guy
Be rich, not famous: The joy of being a nobody – Financial Samurai
Farmland as an asset class [Podcast] – Meb Faber
The top 1%, corporate version – Morningstar
Blockchain hype is fading fast – Streetwise Professor
You still benefit from global equity diversification, but less so nowadays for bonds [Research] – SSRN
Kindle book bargains
Nudge: Improving Decisions About Health, Wealth and Happiness by Richard Thaler – £1.99 on Kindle
Liar’s Poker: From the author of the Big Short by Michael Lewis – £0.99 on Kindle
Freakonomics: A Rogue Economist Explores the Hidden Side of Everything by Steven Levitt & Steven Dubner – £1.99 on Kindle
PostCapitalism: A Guide to Our Future by Paul Mason – £0.99 on Kindle
What would a No Deal Brexit mean for your finances? [Search result] – FT
Carney: No-deal Brexit risk ‘uncomfortably high’ – BBC
London Stock Exchange has triggered its No Deal contingency plan – Business Insider
Not drinking bleach is ‘Project Fear’ says Brexiteer – The Daily Mash
Off our beat
No, you probably don’t have a book in you – The Outline
SpaceX’s secret weapon is Gwynne Shotwell – Bloomberg
The sadness of deleting your old Tweets – Wired
Goop’s haters made Gwyneth Paltrow’s company worth $250 million – New York Times
How Silicon Valley became a den of spies – Politico
The death of the author and the end of empathy – Quillette
“The grim irony of investing, then, is that we investors as a group not only don’t get what we pay for, we get precisely what we don’t pay for. So if we pay for nothing, we get everything.”
– John Bogle, The Little Book of Common Sense Investing
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