For the last forty or so years interest rates in the West have been trending lower. There have been ups and downs, but the direction of interest rates has been unmistakably down. This week’s briefing examines whether, with interest rates heading higher, the era of cheap money has passed.

The UK base rate averaged close to 10% in the 1970s and 1980s. It fell to around 8% in the early to mid-1990s and then, from 2000 until the financial crisis in 2008, it averaged 5%. The financial crisis, the deep recession that ensued and then the pandemic have resulted in a period of record low rates, with UK rates running at an average of 0.5% until late 2021. Sub-1.0% interest rates became the new normal.

A series of factors pushed the equilibrium, or normal interest rates ever lower in this period. A decline in western growth rates depressed demand for investment capital, a process reinforced by a global shift to service-based, less capital-intensive economic activity. The multiple shocks of the last 15 years, everything from the financial crisis to the pandemic, have increased uncertainty and reduced risk appetite. While demand for investment capital has faltered, supply has increased as ageing populations in the rich world save more and households in fast-growing Asian economies accumulate savings. The resulting savings glut has depressed interest rates.

Since the 1980s central banks across the world have been freed from political control and charged with keeping inflation low. This has increased the credibility of monetary policy and helped anchor expectations for inflation and interest rates at lower levels. Globalisation and the entry of China into the global trading system in 2001 have played a role in depressing prices and inflation across the world.

We have moved from a high to a low interest-rate world. Instead of worrying that rates and inflation were too high, as they did in the 1970s and 1980s, policymakers increasingly worried that they were too low. Deflation, not inflation, became the bogeyman.

That changed abruptly in 2022. In the last year inflation rates in Europe and North America approached, or exceeded, 10%. Inflation has become the number one problem. The Bank of England has taken rates from a low of 0.1% in December 2021 to 4.0%, the highest level since 2008. Financial markets anticipate rates will peak at around 4.6% this September.

Now, helped by lower energy prices, inflation seems set on a downward trajectory. Inflation is likely to fall sharply from around the middle of this year. The Bank of England thinks UK inflation will get back to its 2.0% target rate in the first half of 2024. In this environment, with the temporary shocks that drove inflation dissipating, will UK interest rates return to the sub-1.0% levels that, by 2019, had become the norm?

The Bank of England’s chief economist, Huw Pill, thinks not. He believes that the ultra-loose monetary policy of the last 15 years was exceptional and that recent increases in interest rates should be seen as a normalisation of policy. On these arguments low rates were necessary to counter the deflationary effects of the financial and ensuing euro sovereign crises, the challenges of Brexit and of the COVID pandemic. As those shocks fade central banks should move interest rates to a new, higher normal.  

Central bankers also worry that some of the structural factors that have kept inflation and rates low are weakening. The pace of globalisation has slowed in recent years, with geopolitical tensions and a greater focus on national autonomy and self-sufficiency creating new frictions and costs. The cost of goods from China and other emerging markets is rising, not falling as they were 20 years ago. Last year’s inflation shock has increased long-term market and consumer expectations for inflation. Central banks’ credibility, which has helped keep interest rates low in recent decades, has taken a knock. Meanwhile a drive for sustainability and resilience across the economy, above all the energy transition, but also in defence, agriculture, technology, and supply chains, will require vast levels of investment. The International Energy Agency estimates that global energy investment alone needs to rise from a current $2tn a year to $5tn a year by 2030 for at least 20 years to reach net zero CO2 emissions by 2050. Surging demand for capital could push interest rates higher.

As in most things in economics, views vary widely on where interest rates will eventually settle. We see UK rates falling back from a probable peak of around 4.5%-5.0% but running at trend levels that are above the sub-1.0% rates of the last 15 years. One profile for rates is suggested by market pricing. It shows UK rates falling slowly to just below 4% at the end of 2024 and to 3.4% in five years’ time. Our inclination is to think in terms of a new normal, or equilibrium interest rate, of around the 3.0% mark. That number is a speculation rather than a forecast. We feel on firmer ground in thinking that the days of ultra-low interest rates are probably past.

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