Markets do set rates: A reply to Julien Noizet

Financial analyst and blogger Julien Noizet has replied to my article on mortgage rates on his blog. It is a good piece, worth reading, but I still think I am right. It is perhaps true that Noizet is right too, because my claim was really very modest: in total, mortgage interest rates do not mechanically vary with the Bank of England’s base rate; we can show this because the spread between them and the base rate varies extremely widely; and since we have very strong independent reasons to expect that market forces largely drive rate moves, that should be our back-up explanation. The implication of this I was interested in was that this meant a hike in Bank Rate wouldn’t necessarily drive effective rates up to a point that would substantially increase the cost of servicing a mortgage and hence compress the demand for (London) housing.

Even if the first graph in Noizet’s blog post did appear to support his narrative that effective market rates follow Bank Rate moves, I’m not sure why these disaggregated numbers matter given that the spread between overall effective rates on both new and existing mortgages varied so widely. If it turns out that specific mortgage types varied closely with Bank Rate but the overall picture did not, then markets still control effective rates, they just do it via a changing composition of mortgages, not by changing the rates on particular products. The effect is the same—and it is the effect we see in the Bank’s main series for effective rates secured on dwellings. But the graph, to me, looks a lot like mine, despite the effect of new reporting standards: mortgage rates are about a percentage point from the base rate until 2008, then they don’t fall nearly as far as the base rate in 2008 and they stay that way until today. If other Bank schemes, like Funding for Lending or quantitative easing were overwhelming the market then we’d expect the spread to be lower than usual, not much higher.

His second big point, that the spread between the Bank Rate and the rates banks charged on markets couldn’t narrow any further 2009 onwards perplexes me. On the one hand, it is effectively an illustration of my general principle that markets set rates—rates are being determined by banks’ considerations about their bottom line, not Bank Rate moves. On the other hand, it seems internally inconsistent. If banks make money (i.e. the money they need to cover the fixed costs Julien mentions) on the spread between Bank Rate and mortgage rates (i.e. if Bank Rate is important in determining rates, rather than market moves) then the absolute levels of the numbers is irrelevant. It’s the spread that counts. But the whole point of my post is demonstrating that the spread changes very widely, and none of Julien’s evidence seems to me to contradict that claim. Indeed, Noizet’s very very good posts on MMT, which stress how deposit rates are much more important as a funding cost than discount rates for private banks, seem at odds with what he’s written in this post. And supporting this story is the fact that the spread between rates on deposits (both time and sight) and mortgages changes much less widely. If we roughly and readily average time and sight on the one side and average existing and new mortgages on the other, the spread goes no higher than 2.3 percentage points and no lower than 1.48.

In general with the post I don’t feel I understand the mechanisms Noizet is relying on, perhaps I’m misunderstanding him, but the implications of his claims regularly seem to contradict our basic models of markets. For example, he says that a rate rise would lead banks to try and rebuild their margins and profitability. But I can’t see any reason why banks wouldn’t always be doing that. The mortgage market is fairly competitive, at least measured by the numbers of packages on offer and the relatively small differences between their prices. I don’t think Julien has presented any mechanism to suggest why banks would suddenly want to maximise profit after a rate rise but wouldn’t beforehand—or why they’d suddenly be able to ignore their competitors but couldn’t beforehand. It’s possible there is one, but I can’t see that he’s explained it. Overall I suspect I’ve missed something crucial, so I welcome any more comments Julien has on the issue.

Interest rates are set in the market place

The London housing market is booming. According to Nationwide, prices rose 14.9% over 2013. According to Halifax, they climbed 9.4%. According to the Land Registry they were up 11.2%. The Office for National Statistics hasn’t quite got data for the whole year yet, but their numbers show prices up 11.6% in London in the 12 months to November 2013. No doubt Rightmove, LSL, Hometrack and all of the many other indices echo this finding. While we at the ASI have pointed out how the government has jacked up demand with the Help to Buy scheme (some have quipped it might more accurately be termed “Help to Sell”) the Bank of England and Treasury have dialled down the housing element of the Funding for Lending Scheme in response to worries about a bubble and unaffordability.

But however much these schemes are artificially adding to demand, it is certainly clear that London houses—a desirable place for natives and people across the world to live—face a huge demand and are in limited supply. Since this is clear, I have been loath to call the situation a “bubble”—a bubble seems bound to pop, but tight supply and ample demand suggests a situation where prices will remain high (see an excellent post from my colleague Sam for more detail). However, it was recently pointed out to me that since a high fraction of UK mortgages track the Bank of England’s base rate, a jump in rates, something we’d expect as soon as UK economic growth is back on track, could make mortgages much less affordable, clamping down on the demand for housing.

This didn’t chime with my instincts—it would be extremely costly for lenders to vary mortgage rates with Bank Rate so exactly while giving few benefits to consumers—so I set out to check the Bank of England’s data to see if it was in fact the case. What I found was illuminating: despite the prevalence of tracker mortgages the spread between the average rate on both new and existing mortgage loans and Bank Rate varies drastically. For example, it was almost one percentage point in January 2004, fell to 0.5pp by July, rose to around 0.6pp where it stayed until July 2006 when it crashed to nearly zero in a year, before rising to 1pp in October 2008 and then almost 3.5pp in April 2009. Since then it has steadily trended down to around 2.5pp. There are lots of interesting and obvious stories to tell here, hearkening back to my piece about the confusion between interest rates as a stance of monetary policy and interest rates as the actual cost of borrowing firms and consumers face, but what is clear is that tracker mortgages be damned, interest rates are set in the marketplace.

What this means is that the fact the Bank’s base rate will almost certainly be hiked in the next couple of years if economic growth continues at its current healthy pace is not a reason to worry that London’s housing bubble will pop. Indeed, the only way London house prices are likely to drop from their current stratospheric levels is if we get a good honest bit of planning deregulation. Moving the green belt out just one mile would allow us to build one million houses, after all. And it could add percentage points of pure supply-side driven growth to GDP and living standards.

Low rates doesn’t mean low rates

I got called up last Wednesday to ask if anyone at the Adam Smith Institute would go on the Daily Politics to explain why the Bank of England should raise its base rate (not exactly in those words). The producer was familiar with common free market ideas that argue that artificially low interest rates are blowing up a housing bubble which will later burst. I had to try to explain to the producer why I both agree and disagree with these sentiments: low interest rates do underlie economic limbo, but raising the base rate is not a solution and may produce yet lower real interest rates where it matters—throughout the economy.

The problem comes from the dual use, in the popular economic press, and even by top economists, of the term “interest rates” to mean both the stance of monetary policy and the cost of borrowing. This is understandable because during the Great Moderation of 1992-2008 all the world’s most important macroeconomic authorities attempted to control the overall economy through adjusting one or a small number of key interest rates to achieve a consumer price inflation (CPI) target. At the same time, we are familiar with interest rates through our normal life: on loans, mortgages, savings, credit cards and so on. But acting as though the Bank of England directly controls these rates when it adjusts policy seriously obfuscates how the macroeconomy works and contributes to a lot of sloppy thinking.

Whereas the Federal Reserve has always used a form of quantitative easing (QE) to adjust a market interest rate—the Federal Funds Rate—the Bank of England has typically adjusted its base rate, which it calls Bank Rate, instead (updated). Bank Rate is the flat (nominal) interest rate it charges commercial banks for short term funding, and pays on their excess reserves. This sets a lower bound on overnight commercial lending, since it is always an option to lend or borrow money at Bank Rate, and therefore it is included in some market contracts, like tracker variable rate mortgages. The current UK base rate is 0.5%, a nominal number which translates to a negative real rate, but secured loans charge more like 3% in nominal terms, unsecured loans 8%, and credit cards 10%.

So we’ve established that the Bank of England sets a lower bound on interest rates with its Bank Rate. And we’ve also established that Bank Rate affects some other rates directly, principally tracker mortgages. We might also expect it to affect other rates in the economy—for example a cut will “ripple out” through the economy, because all other things being equal, it is now cheaper for banks to borrow from the BoE and they will thus be more willing to do so. Economists call this the liquidity effect. They will thus be more willing to lend cheaply and less willing to borrow from savers. So one effect of lowering the Bank Rate is to directly lower some rates, put a lower lower bound on others, and make others cheaper.

However there is an opposed reaction. Lowering Bank Rate doesn’t just make loans cheaper, but it increases demand. It does so by injecting extra money into the economy (from the extra loans), but more importantly by signalling to markets that it intends demand to grow faster and that it is willing to take measures (such as further lowering Bank Rate or boosting the money supply through a QE programme) to make sure this happens. This is why stock markets react so strongly to a (policy) interest rate cut—all businesses are worth a bit more because they expect higher total revenues over their future.

But if firms expect higher demand in the future they will in turn demand more investment funds to put into projects to service that demand. This means that cutting the BoE’s base rate puts pressure on effective market interest rates in both directions. It is an empirical question which direction the overall effect goes in—but this means that the simple coincidence of low real effective interest rates out in the economy and a low, by historical terms, Bank Rate, shows nothing. It could be that the best way to raise interest rates out there in the economy is to cut the Bank’s base rate, or, since it can’t go much further now, print money to raise inflation (which would ceteris paribus cut the rate in real terms). Look at the graph above for an illustration of how the Fed’s changes in their QE programme (the red line) and their Federal Funds rate (the dark blue line) don’t produce big shifts in (real) market interest rates like corporate bond returns and 30-year mortgages.

So my view on low interest rates is complicated. I think the Bank should get out of the business of setting rates altogether, and vary the size of the monetary base to control nominal income in the economy. But if the Bank is going to use rates as its key policy tool, it shouldn’t raise them when a recovery hasn’t quite taken hold—it’s uncertain whether it’ll raise market interest rates, but it will certainly choke off the demand we need for solid growth.

Rare sensible move from Mario Draghi and ECB

Nominal interest rates cannot be brought below zero, because non-cash assets can be sold for cash, which always effectively bears an interest rate of zero. Monetary policy affects the economy through changing nominal interest rates, which given somewhat sticky inflation changes real interest rates, which affects spending, saving and investment decisions—a cut in the interest rate makes saving more expensive and investment cheaper. Essentially working on these two facts (there are much more complex versions, but this is the core) New Keynesian economists argue there is a “zero lower bound” on monetary policy. The Fed cannot support demand by targeting a Fed Funds rate lower than zero, the Bank of England cannot support demand by lowering Bank Rate any further than zero, and the same for the European Central Bank. This means, they say, fiscal policy is necessary to stabilise demand when the interest rate that would be needed to do falls below zero.

Now I think this argument is false. Monetary policy does not mainly work through interest rates. Monetary policy mainly works through affecting consumers’ and firms’ expectations about future demand conditions. But even if this argument were true, the simple Keynesian story—that fiscal policy must be employed to get the Eurozone out of recession because monetary policy is ineffective at the zero lower bound—will not fly. Why? Because the ECB, headed by Mario Draghi, cut interest rates by 0.25% today, bringing them from 0.5% to 0.25%. The ECB was not yet at the zero lower bound.

Monetary policy doesn’t seem to need long and variable lags of the type typically assumed in models. As I write, the Euro is down 1.4% against the dollar 1% against the pound and 0.7% against the yen. The Bloomberg 500 measure of European stocks is up 1% and the Euro Stoxx 50 measure is up 1.3%. That means the value of the Euro has already fallen. That means that money is already slightly easier. If there were a good measure of nominal income expectations—the best definition of money easiness or tightness—I’d wager that that would be up.

It’s true that this is unlikely to be enough. Nominal GDP is not growing at pre-trend rates, never mind catching up to the pre-recession trend. The ECB is letting the euro area slip into deflation when it is barely out of its double-dip recession. Sovereign debts have grown to eye-watering levels despite very tight fiscal policies in many of the hardest-hit member nations. And none of this is to mention the excessive regulation and badly-designed tax systems that contribute to low long-run productivity growth and high rates of unemployment even in good times. But it’s both a step in the right direction, and evidence against the simplistic Keynesian arguments that get trotted out all too often in macroeconomic debate.

Inflation drivel

Labour’s economic team—led by Ed Balls—is either confused and economically ignorant, or deliberately misleading and opportunistic. After Tuesday’s inflation release, they hit out at the government for the continued above-target rate (2.7% over the year to September, the same as over the year to August), as part of their new “cost of living” strategy. Spokesperson Catherine McKinnell said:

This is yet more evidence of the cost-of-living crisis facing families across Britain after three years of this Government’s failing policies. Prices have now risen faster than wages in 39 out of 40 months under David Cameron and now we learn that we have the highest rate of inflation of any EU country.

At the same time, shadow chancellor Ed Balls has repeatedly attacked the Tories’ fiscal austerity policies, blaming them for the extremely lacklustre recovery from the recession and even suggesting they may have been self-defeating. But at the same time he has also blamed above-target inflation for squeezing living standards.

But which is it? If the Tories were wrong to cut spending, it’s because the recession was driven by nominal factors, and cutting spending will further cut aggregate demand, only worsening the pricing mismatch that is leaving resources unemployed and output below potential. But we also know from our basic AD/AS model, the same one that we use to generate the result that falling aggregate demand is bad for output and employment, that higher AD means higher inflation. So if Ed Balls really wants more government spending, any of the models he’s relying on would also tell him he’d have to have higher inflation as well. You can’t criticise austerity and inflation.

But it goes deeper than this. What Ed Balls is missing is that actually the UK’s overall economic policy wasn’t particularly austere at all. Certainly at points it could have standed to be a bit easier, especially in the crucial 2008-2009 crash. But basically Ed Balls completely ignores monetary policy, which, in the final analysis, determines demand. The monetary policy committee, which sets rates and quantitative easing (QE) can choose whatever it wants demand in the economy to be. They use a faulty indicator, the consumer prices index. But they interact with the economy by constricting or expanding demand based on their policy goals (inflation close to 2%, stable output and employment).

Imagine the government decided to cut spending by £100bn (an illustrative number). If this was going to bring inflation down to 0%, from 2%, then the Bank of England would be changing its monetary policy if it allowed inflation to fall there. The Bank, knowing this, will manipulate interest rates and asset buying policy (QE) to make sure their goals are met. This is true even though the Bank’s current framework leaves so much to be desired. In 2010 and 2011 the Bank allowed inflation to go all the way up to 5.2%, meaning that they more than counteracted the effect of austerity on overall aggregate demand.

What this means is that Ed Balls, were he to slow down the pace of fiscal contraction and nevertheless bring inflation down to 2% now, would worsen the nominal recession, and yet redistribute yet more resources to state control. He may not know this—despite his economic education—or he may be staking out a deliberately misleading and opportunistic set of policies, playing on the public’s ignorance of economics.