The death of interest rates

A few years ago, not long after the Bank of England started its quantitative easing programme, someone who had just been appointed to the Monetary Policy Committee lamented to me that he would probably never get to change interest rates at all. At the time, I assumed he was joking – after all, surely Bank rate wouldn’t be left unchanged at 0.5% for three years, let alone six years if he was reappointed for a second MPC term?

Clearly I was wrong. It’s now been more than four years since the Bank’s interest rate was last changed. It’s been four and a half years since the Federal Reserve changed interest rates in the US – same for the Bank of Japan, whose interest rate has been below 0.5% since late 1995.


All of which raises the question: are we living through the death of interest rates – or at least the use by central banks of interest rates as a tool to manage the economy?

Consider it the following points:

1) Today the Bank of Japan committed itself to an enormous new round of quantitative easing, pledging to double the size of its balance sheet and to buy up longer-dated government bonds, rather than the short-dated stuff it bought in previous rounds of Tokyo QE. As a result of this the central bank’s balance  sheet which was recently overtaken, for the first time, by the ECB’s, will balloon to around 60% of GDP.

Size of central banks' balance sheets. Stolen from a James Bullard presentation:
Size of central banks’ balance sheets. Stolen from a James Bullard presentation

More profoundly, as Martin Schulz of the Fujitsu Institute put it on the radio this morning, in essence the BoJ is abandoning any pretence of trying to use short term interest rates as a tool (with a bit of QE as a backup) and is going the whole hog and directly manipulating the quantity of government bonds both in its balance sheet and in the wider economy.

2) The incoming Bank of England Governor, Mark Carney, is known to be keen on pre-committing to low interest rates. Many expect him to pre-commit the UK to low rates for years when he takes office.

3) The Federal Reserve has pre-committed to low interest rates for the foreseeable future, and more quantitative easing until unemployment drops considerably from where it is now.

4) A number of other central banks – most notably the Swiss National Bank – are focusing not on inflation or domestic growth or any other familiar economic target, but on keeping the Swiss Franc from rising too far.

In other words, it’s likely that, at the very least, interest rates will remain at or near rock bottom for some time and that they will be an irrelevance for central banks and economic policy for years to come.

This might seem odd to those of us who have become accustomed to seeing interest rates as the key policy tool for a central bank. However, a look back into even recent history should remind us that, if anything, the recent few decades have been the exception rather than the norm. After all, for most of the Bank of England’s history interest rates were set largely in order to comply with the system of fixed exchange rates (the Gold Standard, Bretton Woods system and then Exchange Rate Mechanism). The level of interest rates was a direct function of the UK’s interaction with the international monetary system. Really, the UK domestic fixation with interest rates only dates back to 1992, when Britain really regained monetary independence.

Until the 1980s the Federal Reserve managed its monetary policy without even announcing interest rates publicly – rates would instead have to be inferred by eagle-eyed traders from the Fed’s operations buying up government debt in the markets.

The reality is that in many senses, a central bank’s announced policy rate is, or was, a convenient proxy for a lot of more complicated stuff going on beneath the surface: the bank modifying the size and shape of its balance sheet, buying up government debt, issuing short-term securities and so on. Now that policy rates are at zero, and no going anywhere, we are left without that convenient façade and instead we have a glimpse of the machine’s inner workings: that central banks routinely have to buy and sell government debt in order to moderate the flow of cash around the economy.

That’s not to underplay the significance of what’s happened in Japan, or is happening in the UK and US. We are witnessing a swell in the size of central banks’ balance sheets – an international monetary blitz – of the kind we have never seen before.