ILC-UK Economic Insights: Damned if they do damned if they don’t: Central banks in the new normal

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Population ageing is driving down inflationary pressures and reducing real interest rates which gives central banks very little room for manoeuvre.

The Bank of England has come under a lot of flak over the last few weeks for its policy of quantitative easing and the ultra-low base rate. In particular, those who have criticised the Bank’s policies argue that this is unnecessarily eroding returns for savers including reducing annuity rates for pensioners. In short, critics argue that poor outcomes for savers and pensioners are directly due to the Bank of England’s actions. We must therefore reverse the Bank’s policies before more damage is done.

Let’s go back to basics

In order to counter this view, we need to go back to basics. What is a central bank for?

Before the 1990s, monetary policy – that is the setting of interest rates or altering the quantity of money in the economy – was the preserve of the government of the day. As William Phillips observed 50 years ago, higher rates of inflation were correlated with lower rates of unemployment. Consequently, governments who were keen to remain in power were tempted to use monetary policy as a means of raising inflation and therefore reducing unemployment around election times.

The problem with this strategy was that it only worked to reduce unemployment in the short run as for a limited amount of time it made the employment of new labour cheaper. In the long run, employers and workers display rational expectations, taking inflation into account, resulting in employment contracts that increase pay at rates near anticipated inflation. Unemployment then begins to rise back to its previous level, but now it will coincide with higher inflation. This was a key factor in explaining the so called stagflation in the 1970s. In response to the inherent risk that governments would hijack monetary policy for their own ends to the detriment of the economy as a whole, governments around the world legislated to give central banks independence. In turn, since targeting unemployment was futile, central banks were given a stable inflation target – which in the UK’s case is 2%.

Central banks are responding to unprecedented times

Since the financial crisis of 2008, it has become increasingly apparent that our level of productivity growth – that is the output per worker – has slowed, while inflation over the last couple of years has remained very low. Inflation rose in the aftermath of the crisis as a consequence of the falling value of sterling and rises in registered and administered prices (i.e. tuition fees, rail fares etc.) but since 2014 it has hovered between 0% and 1.7%. This is driving down what economists call the real rate of interest – this is the rateat which realGDP is growing at its trendrate, and inflation is stable. This in turn is reflected in the Bank of England’s monetary policy.

To what extent does central bank policy reflect underlying fundamentals?

In order to show how economic fundamentals impact on the base rate we have estimated a simple Taylor Rule. This estimates the statistical relationship between the historic base rate and a one quarter lag of inflation and unemployment. These two economic variables explain 93% of the variation in the base rate since 1989 – a very strong fit. Interestingly, our analysis suggests that based on the historic relationship between these economic fundamentals and the base rate, the base rate should be even lower than it currently is (around -1%). With the economy far from overheating, deflation, not inflation is the central bank’s concern.


Source: Author’s calculations based on ONS and BoE data

So what’s driving low interest rates and low inflation?

While many commentators have been fixated on low interest rates in the UK, it is worth noting that many countries are in the same boat. Indeed, countries across the developed world are experiencing falling interest rates, and, crucially it reflects a trend stemming from way before the 2008 crisis and subsequent unconventional central bank activity. On the chart below we have plotted nominal yields on government bonds across a number of countries. As you can see, yields have been falling consistently since the 1990s (this is true even after accounting for inflation).


Source: Author’s analysis of OECD data

Underpinning all this is a slowdown in trend productivity growth – the UK economy much like the rest of the developed world is anything but overheating. Advanced economies are currently about 1 percentage point below their pre-crisis rate of growth (see chart), and are expected to remain there over the next five years.

Source: Author’s analysis of IMF data

Why is a turnaround unlikely?

The great Canadian economist John Kenneth Galbraith once said “the only function of economic forecasting is to makeastrologylook respectable”. Predicting the future is fraught with difficulties, but one thing we can be reasonably confident about, barring a world war or sudden pandemic, is the ageing of populations around the world. And it just so happens that changes to age structures impact on economic fundamentals. Growth amongst the younger population happens to have a strong relationship with increased inflation, while growth amongst the older population is related to lower levels of inflation or even deflation. This would imply that population ageing is likely to reduce rather than increase interest rates over time (see charts – each dot represents 1 year).


Source: OECD and author’s calculations

Central banks at the limit of their powers

With the base rate close to zero and having undertaken stimulus in the form quantitative easing to drive up demand, the Bank of England has reached the limit of what it can do. Critics may argue about the relative merits and distributional impacts of its approach, but these are truly extraordinary times. The critical question is not whether what the central banks have done is appropriate, but what else can they do to help boost long run productivity while ensuring that they have sufficient room to manoeuvre should a recession loom large once again. In the absence of fiscal stimulus, central banks are the only game in town. Expect more unconventional policy coming our way soon. Watch out for helicopters bearing cash!

Ben Franklin
Head of Economics of Ageing

Dean Hochlaf
Research and Policy Intern

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