I write this column every fortnight, and every fortnight it seems we have a big new expensive policy from Rishi Sunak. Last week the chancellor opened the purse strings once again, extending the furlough scheme right through to the end of March. That, alongside another four weeks of England-wide lockdown (at least), will add to this year’s deficit, a deficit already set to be the biggest in UK history outside of the two world wars.
One day, though, that scheme will, presumably, come to an end. The deficit will, eventually, come down. What I’m not so sure about is what will happen to monetary policy.
Somewhat less remarked upon than this latest dose of chancellorial largesse, Thursday also brought the announcement of another £150 billion of quantitative easing from the Bank of England. The Bank will soon be holding nearly £900 billion of government debt. That is one of the things keeping the interest rate on that debt at record low levels — that and the record low levels of the Bank of England bank rate, reduced to only 0.1 per cent at the start of the pandemic.
Remember the last crisis back in 2009: the Bank of England then had space to make serious cuts to bank rate, from 5.25 per cent at the start of 2008 to 0.5 per cent in March 2009. It climbed to only 0.75 per cent over nine years later in August 2018.
Quantitative easing was a whole new form of monetary policy in this country. The Bank first announced purchases of government debt of £200 billion in November 2009. That had climbed to £445 billion by the time the current crisis hit.
What is really remarkable is that what we thought was a short-term change in monetary policy to deal with the financial crisis seems to have turned into a new normal. Record low interest rates never went away. The QE programme was not unwound, it was expanded. At the same time, the interest payable on government debt continued to fall.
None of this was anticipated. Expected increases in the bank rate never materialised. The Office for Budget Responsibility had to revise down its forecasts of future debt interest payments year after year after year as gilt rates not only failed to return to more “normal” levels but actually kept falling. They have continued to slide in recent months, even as the government has sold ever increasing amounts of debt.
Purchasers are willing to accept staggeringly low returns. For example, the Debt Management Office recently auctioned nearly £500 million of index-linked gilts with a 2056 maturity for a return of RPI minus 2 per cent. To put that another way, investors were happy to buy government debt with a guarantee of getting back about half of their investment after inflation in nearly 40 years’ time. Given how long interest rates of all kinds have remained low, and falling, it seems likely that we will be living with negative real rates for some time to come. Nobody is expecting the Bank of England to sell its holdings of government debt any time soon.
All of this has huge consequences. First, ultra-low interest rates keep asset prices high. Falling interest rates over the past three decades have been the main driver of ever-increasing house prices. This has big distributional effects. Older homeowners have benefited at the expense of younger people seeking to get on the housing ladder. The fact that the government’s fiscal and welfare policy also has protected the old and hit the young has simply exacerbated an unintended redistribution from one generation to another. It seems likely that the present combination of policies will ensure this effect continues.
Second, if real interest rates on “safe” assets are negative, it essentially becomes impossible for anyone to save enough for retirement without taking serious risks with their savings. In a world of individual pensions and savings accounts, that is, obviously, risky. It has become impossible, too, to buy an annuity at a rate that looks even vaguely attractive because annuity providers are required to invest in safe assets. Low interest rates, accompanied by strict regulation, force people into risky behaviours and destroy annuity markets that have grown up over centuries.
Third, the effect on traditional final-salary pensions has been catastrophic. Such schemes are big holders of government debt, an asset providing negative real returns, in large part because they are required to do so for regulatory purposes. As interest rates fall, their required holdings rise. In a recent report, my colleagues at the Institute for Fiscal Studies looked at the impact of the pandemic on the finances of universities. By far the biggest damage will come through its impact on the University Superannuation Scheme, not on things like whether they can keep attracting students. The impact on the cost and value of public sector pensions has been, and will again be, huge.
Finally, this leaves the government with a quandary. It seems to be able to borrow as much as it wants pretty much for free. That must be tempting. This makes it the perfect moment to make valuable investments. But there are big risks. The temptation towards wasteful spending is all too evident. That would make us worse off. And if interest rates do start rising without a corresponding increase in economic growth, then we could easily descend into a horrible fiscal spiral from which recovery could be painful.
For obvious reasons, austerity and its impacts have consumed our attention over the past decade. In 2020 the same has been true of enormous levels of public spending in response to the pandemic. Yet when economic historians look back on the period from 2008 and on through this crisis, they may well conclude that it was monetary policy and ultra-low interest rates that had the bigger long-term consequences for the country and its citizens.