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Economics Weekly

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How low can official interest rates go?

Wed, Nov 12 2008, 05:30 GMT
by Trevor Williams

Lloyds TSB Financial Markets

Slowing economic growth and falling inflation is leading to record low interest rates…
Interest rates are being cut aggressively around the world as economic growth slows and as price inflation either falls back from recent peaks or is set to fall sharply in the months ahead. A worsening of the credit crisis since the failure of Lehman Brothers two months ago, has noticeably hit expectations for growth and inflation. In many countries, prospects for price inflation are helped by the fact that wage inflation is well-behaved, meaning that it is well below price inflation. How low can interest rates go in some of the major economies? One starting point is the approach used in the so-called ‘Taylor rule’, which calculates the extent to which inflation and growth deviate from their long run averages, subtracts this from long run real interest rates and then adds expected inflation to get an estimate of what the short term official interest rate should be. We have calculated these rates for the US, UK and eurozone. What do they show? The answer is that overall they show that interest rates in the advanced economies have a further 1 to 2 percentage points to fall.

An analysis of the results from calculating Taylor rule rates for the US reveals an official rate of 3.75%, well above the current interest rate of 1%, see chart b. But central banks set short term interest rates in a forward looking way and, if this is taken into account, then it explains why there is such a large gap between the two rates. But in order for that calculation to work, we have to assume that price inflation falls well below its long term average, and that the economy weakens further, so that a big negative output gap opens up. This is, of course, exactly what forecasts are suggesting and so doing this largely explains the gap between the actual central bank base rate and the Taylor rule rate. IMF forecasts now show that growth in the advanced economies will be negative in 2009, the first synchronised decline since the second world war.

…analysis using the ‘Taylor rule’ suggests that interest rates can be cut further…
So assuming more negative forecast outcomes for economic growth and inflation into a Taylor rule framework supports the current 1% level for US interest rates. Interestingly, official short term interest rates could even be cut below the levels seen so far, if growth and inflation weaken further. This is instructive, as the history of the Taylor rule set against the official actual central bank rate shows that it has generally been a good guide to actual rates. In addition, market interest rates are still well above the official rate in the US, UK and euro area, see chart a, even though they have come down in the last few days. If this is allowed for, then it too suggests that the Fed funds rate should be 1%, in order to get market interest rates to a level implied by the Taylor rule, based on the traditional spread between official rates and market rates.

...in the case of the UK, to 1½% in 2009, if the economy experiences a downturn as severe as in 1990, and to zero if recession carries over into 2010
For the UK, what does the Taylor rule suggest? Chart c shows that the rule suggested that Bank rate should be cut to 3%, though in early 2009. But this does not take into consideration the fact that market rates are well above the official rate. If this is taken into account, then it suggests that UK rates should be cut to 2% in the near future. Our forecast is that rates will be cut ½% in December to 2.5% and then in February 2009 to 2%, but it could happen sooner. They could then stay at 2% throughout 2009. The fiscal policy response may well play a key role in whether this becomes the actual outcome. If tax cuts and spending increases are large enough to promote economic recovery, then Bank rate may not be cut as aggressively as we currently expect. We have also calculated where UK rates may have to be cut to, if the economy slips into a deep recession, see chart c. This would open up a wide enough output gap for price inflation to turn negative, which is a view held by some. In this case, UK interest rates would fall to 1½% by mid 2009 and, if the recession persists into 2010, to zero by the end of that year.

It looks as if interest rates in many of the major advanced economies will fall to new lows
In the case of the eurozone, the Taylor rule suggests that the ECB was right to cut rates to the current 3.75%. However, given market dislocation and the spread of market rates over the ECB repo rate, euro zone rates will need to come down by another 1.25 percentage points to 2.5% to get money market rates down to about 3½%.

The Taylor rule approach highlights that there are further cuts in short term interest to come, even though they have already been cut to historically very low levels in all three of the economies looked at in this analysis. Another factor encouraging cuts in nominal interest rates is that if inflation falls and interest rates are not cut, that translates into a rise in real interest rates at a time when the economy is in recession. To avoid this, Central banks in the advanced economies are willing to cut interest rates to below inflation, at least in terms of backward-looking past measures of inflation. In terms of forward looking real interest rates, lower nominal interest rates now are still needed to prevent too sharp a rise in future real interest rates.

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Published on  Wed, Nov 12 2008, 06:33 GMT