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What Will Post-Shock Britain's Interest Rates Look Like?


Image Source: dailyprofitcycle.com


As the financial landscape shifts with the Bank of England raising interest rates and inflation beginning its downward trajectory, households might anticipate a respite from the incessant cost of living crisis. Yet, the waning inflation rate doesn't signal an all-clear. As we navigate these turbulent economic waters, another ominous wave looms on the horizon - a 'cost of credit' crisis.


While the falling inflation does imply that the Bank of England might not need to resort to drastic rate hikes, offering some alleviation to households, the imminent cost of credit crisis poses a pressing question: how long will this impending economic instability last? Mainstream economic theory suggests that the stormy seas should calm once the turbulence caused by real shocks, such as geopolitical conflicts or the pandemic, is addressed and inflation returns to its target. Some financial commentators, drawing parallels with the US economy, posit that UK rates could also revert to their pre-COVID levels once the relevant real shocks, including those associated with the Ukrainian War, dissipate and inflation expectations align with the 2% target. Under these circumstances, central banks can begin the process of steering interest rates back towards the 'natural rate' – alternatively "R-star.”


This is the rate at which the economy's supply of and demand for funds intersect, and it is a crucial consideration for monetary policy’s benchmark-setting. This long-term rate balances the cost of government debt while neither accelerating nor decelerating inflation.


This line of thought draws on the concept of monetary policy neutrality, suggesting that monetary policy impacts only nominal factors, like the money supply, without exerting real influence on the economy. But what if we challenge this seemingly commonsensical theory?


The 'cost of credit' crisis is set to cast a deep shadow over the UK housing market. Unlike the US, where 30-year fixed-rate mortgages are more prevalent, UK mortgages typically come with variable rates re-set every 2 to 5 years. This means the current interest rate hikes by the Bank of England can drastically inflate mortgage costs for a significant number of UK homeowners.


The signs are already visible. There are increasing instances of repossession rates rising and missed rent payments. If this trend continues, the UK housing market may be compelled to mirror the US model, leading to a rise in longer-term fixed-rate mortgages. If higher debt repayments on mortgages trigger extended fixed-rate periods, nominal factors, such as interest rates, will directly impact the real structure of our economy, fundamentally contradicting the neutrality of monetary policy.


This change could create a housing market that is less sensitive to interest rate fluctuations. Rent or mortgage payments may become more stable, thereby providing households with less volatile disposable incomes, albeit under the pressure of high-interest rates.


In a post-shock environment, revisiting R-star, the natural rate of interest, is crucial. R-star slipped out of economists' active vocabulary as immediate crisis management took precedence during the upheavals of the pandemic and geopolitical tensions. Now, as the economic shocks recede, policymakers must revisit this critical indicator to inform their decisions accurately.


The inherent assumption that the economy will revert to the same natural rate of interest or R-star, once 'real shocks' are resolved seems flawed. If we consider a less responsive housing market, it would necessitate higher interest rates to achieve the same level of influence on disposable incomes and maintain inflation targets. Therefore, R-star for the UK could be higher than it was prior to the COVID-19 pandemic and the Russian war in Ukraine.


As we venture further into these changing financial landscapes, economists and policymakers need to re-engage with the concept of R-star, the natural rate of interest. A clear understanding of R-star and the potential non-neutrality of monetary policy is critical to set appropriate benchmarks for monetary policy that take into account the transformed economic structures and patterns of behaviour resulting from the shocks experienced in the recent past.



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