Naturally interested- (12.09.04)

According to a recent article in the FT (August 26th) a recent study at the Bank of England identified a neutral point at which monetary policy neither stimulates nor slows the economy. They estimate that is around 6%, a real interest rate of 3.5% with 2.5% inflation. This is based on the level of economic growth plus productivity improvements to reflect the growth capacity in the economy.

We at have long suggested that this type of natural rate is likely to exist, although in reality its existance would only be transitory. It is highly unlikely that actual interest rates would settle at the theoretical long term rate given the dynamic nature of a modern economy. Any policy maker who tried to impose it would always run the risk of getting the rate wrong and adversly affecting the growth in the economy as a result. The reality is that market expectations of the long term rate (e.g. through gilt rates) would indiciate expectations of future UK base rates at around 5.25%.

A more likely forecast is that interest rates will not even reach 5.25%. Oil price rises and the affect of higher taxation and public borrowing do not appear to have had inflationary consequences, perhaps because of the competitive nature of UK retail markets. As long as this competitiveness remains, interest rates can probably be contained below this natural rate. Given the low level of unemployment and high level of job vacancies, we would expect to see wage inflation. Employers currently seem able to resist this. Their reward may be a lower than expected peak in interest rates, whatever the natural rate may suggest.