More about Real Interest Rates

An interest in inflation
Financial Times, Editorial comment, May 11, 2001

Falling world interest rates may be good news for the markets, and they may help to reduce the risks of a global slowdown, but they leave savers feeling squeezed.

Nominal yields of less than 5 per cent seem tiny compared with the levels we got used to over the past 40 years. But in the sweep of history, they are closer to the norm. Victorian rentiers were able to prosper on 2 to 3 per cent.

The crucial test is the level of real interest rates, after allowing for inflation. Here the short-term outlook - at least in continental Europe - brings bad news for savers. Friday brought a sharp rise in continental European inflation only the day after the European Central Bank cut its main lending rate by a quarter percentage point to 4.5 per cent. Average inflation in the euro-zone is thought to have risen to 2.6 per cent in March.

Meanwhile in the UK, where the Bank of England's rate moved down another quarter point to 5.25 per cent, real savings rates for higher-rate tax payers are moving close to zero. A rate of 5 per cent on a savings account translates to 3 per cent after tax and only 0.5 per cent in real terms, assuming that the Bank hits its inflation target of 2.5 per cent.

In a low-inflation world savers need also to consider the measurement of inflation. Quite small differences can be significant. UK inflation, for example, is 2.3 per cent on its headline measure, 1.9 per cent excluding mortgage interest payments but only 1 per cent on the ECB's harmonised index of consumer prices.

Investors might also consider the tendency of inflation indices to overestimate inflation because of their failure to capture effects such as increased quality and specifications for apparently similar goods. According to some estimates that may represent an over-recording of between 0.5 and 2 percentage points.

So are real interest rates really falling? The simplest way to answer is by looking at bank base rates minus inflation.

In the UK, the variation has been remarkable. In 1975, when inflation surged after the oil price rise, the real interest rate plunged to minus 16.5 per cent - a disaster for many savers that was not put right until the end of 1981, when real rates climbed back to 3 per cent.

Then in the mid-1980s, when official interest rates were relatively high and inflation was subdued, savers enjoyed real rates of interest of 7 per cent or more, with a peak of 8.6 per cent in 1985.

It was not until 1994, when the inflationary splurge at the turn of the decade was finally conquered, that real interest rates settled into a more stable pattern, staying mostly at between 3 and 4 per cent.

The question now is whether that pattern is giving way to a period of lower real interest rates, perhaps partly in response to the diminished risk of unpredicted inflation spikes. The trend of rates from index-linked government bonds might suggest as much.

Between 1986 and the end of 1997, the UK indexed gilt yield averaged 3.8 per cent - but in the last 3½ years the average rate has been 2.2 per cent.

In the US, the indexed bond yield is now 3.7 per cent compared with an average of 4.4 per cent last year. But that decline doubtless reflects the effect of a slowing economy on demand for capital.

For the longer term, savers need to ask whether the present stability of prices is likely to persist; for if not, lower rates could present a real threat. There are several reasons for optimism, particularly in Europe. The ECB and the Bank of England now have the independence and the determination to prevent a repeat of previous monetary excesses. Both are now faced with a fiscal loosening - on the spending side in the UK and from a round of tax cutting in Europe - but as Otmar Issing, the ECB chief economist, remarked recently, large "imbalances" are not expected.

The Organisation for Economic Co-operation and Development endorses this view in its recent Outlook. It projects stable inflation of 2 per cent in Europe during the next five years and only 1.7 per cent for the developed world as whole. This would prove to be a benign condition for steady growth - encouraging investment and improving competition through greater price transparency.

That is good news. But in countries such as the UK, which have been used to volatile inflation rates, adjustment to the the new era is needed. Pension funds and providers, for example, have been slow to adjust to lower nominal rates, with serious consequences in the case of Equitable Life.

More broadly, after the pricking of the technology bubble, savers and investors must learn to live in a world where great expectations are closer to Victorian values.

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More about Real Interest Rates

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