How Long Will Interest Rates Stay Low?

With Bank of England Base rates reaching more or less rock bottom (0.5%). The big question is how long will rates stay so low? Interest rates reached 0.5% in March and have kept low through the summer of 2009.

In the experience of Japan, interest rates remained close to zero for over a decade. Basically, Japan got stuck in a deflationary spiral. With asset prices falling for over 12 years the authorities struggled to boost demand, economic growth and any inflationary pressure. If the UK were to get locked in a deflationary spiral, we would see a similar period of zero or very low interest rates.

Interest rates have fallen to 0.5%, but so far there seems no convincing end in sight for the steepest recession since the Great Depression. This suggests conventional Monetary Policy has become ineffective because of the steep asset price falls and stagnation in bank lending.

However, interest rate cuts usually have a time lag (upto 18 months). Combined with expansionary fiscal policy, low value of sterling and new policy of quantitiative easing, there is a good chance of an economic recovery within a year.

The effects of quantitative easing on inflation is hard to quantify. Traditional analysis (in normal times) suggests printing money causes inflation. This link is not as simple though. With falling velocity of circulation, it is possible to increase money supply without inflation. For more details see: effect of printing money on economy

However, when the economy recovers and therefore velocity of circulation increases (number of times money changes hands) we are likely to see an increase in inflationary pressure. The extent of inflation depends on whether the Bank of England can easily reverse the boost in the money supply. This might prove difficult.

When the economy recovers, there is the prospect of inflationary pressure coming back quite quickly. Therefore, we could soon see interest rates increase quickly.

Note: interest rates have fallen so much because rate cuts have become less effective. Therefore, when inflation returns, interest rates may increase to 5% as quickly as they came down.

At the moment, we cannot say with certainty how long interest rates will stay low. The fundamental issue is how long the economy remains in recession. As long as the economy is contracting or we have deflationary pressures, interest rates will stay low. But, as soon as economy recovers and inflation returns, interest rates are liable to rise quite quickly.

However, the size of the budget deficit means the government will have to adopt a more deflationary stance on fiscal policy. Tax cuts will expire and this could harm the economic recovery. If taxes do rise, it means there is more pressure on monetary policy to take up the slack – (keep interest rates low)

So if you can get a good fixed rate deal in the next 12 months, it could prove a very good investment.