Mark Carney, the newly appointed Governor of the Bank of England and Mario Draghi, the President of the European Central Bank, last week signalled that interest rates would remain low for years to come in a push to drive growth. The statements were not coordinated, even though it seems that they were.
After all, the two institutions are independent of each other and of the governments that appointed them. However, they tell a very clear story. And it is worth understanding what that story is.
Each in their own manner, Draghi and Carney have sought to put an end to the recent market turmoil that has sent government borrowing costs soaring throughout much of the developed world. Investors (or speculators) were essentially betting that there would be an increase in interest rates, which got factored into sovereign bond prices.
Some economists are now saying that there may not be a rate rise before 2015. Markets responded quite quickly as equity prices rose and borrowing costs for governments decreased.
In effect there was a departure from previous practice in that both the Bank of England and the European Central Bank adopted a form of ‘forward guidance’ to the financial markets.
Draghi’s statement said: “The Governing Council expects the key ECB interest rates to remain at present or lower levels for an extended period of time.”
Usually, the decision on interest rates would not give any indication of projections into the future.
The position of the Bank of England is even more marked with the comment that “the significant upward movement in market interest rates would weigh on growth” and that a rise in interest rates was not warranted by the developments in the UK economy.
Analysts are now expecting that in the near future, this element of forward guidance will become clearer with a statement that will link any possible rate if interest increases with specific developments in the economy, such as the level of unemployment.
Such comments are very significant also because it is becoming increasingly evident that both the Bank of England and the European Central Bank are putting economic growth as one of their key priorities alongside price stability and currency stability.
Up to a few years ago this was not the case.
The reason for all this is clear – the risk of a prolonged recession is still there. When addressing the European Parliament this week, Draghi said the eurozone’s persistent recession is weakening its banking system and is the most pressing risk it currently faces.
The economy in the Euro area has shrunk for six successive quarters and unemployment has risen to record levels. Asked what he sees as the main systemic risk, he identified the recession. Even so, Draghi claimed that countries still need to get their public finances in order and that fiscal consolidation is unavoidable.
However, such fiscal consolidation needs to be growth-friendly through the lowering of taxes, the lower of public current expenditures and the implementation of structural reforms.
In the UK, the situation is not any different as growth is still likely to be limited, in spite of the good news this week that the International Monetary Fund is revising upwards the growth forecast for the UK, and as such the Bank of England is unlikely to rush into raising interest rates.
Therefore the message is one – keep interest rates low (at the current level of 0.5 per cent) to support economic growth.
This line of thinking is well known to students of economics.
Low interest rates stimulate consumer demand and business investment, while not pushing upwards the value of the currency.
On the other hand, low interest rates reduce the savings rate, which is not necessarily a positive development. Moreover, if banks are not willing to extend credit to the business sector (as is happening in a number of countries), low interest rates may not be of much use.
Having such low interest rates for several months to come is likely to create a scenario of threats and opportunities for our economy. Should we have a proper debate as to how this is likely to impact our economy and avoid the temptation to consider such developments as being too remote from us?