october 2009 

Low interest rates for years, says study

Base interest rates will stay at 0.5% until at least 2011, and remain below 2% until 2014, according to a new report from economic consultancy the centre for economics and business research (cebr).

The forecasts, published earlier this month, are the first to build in the effect of a major fiscal consolidation in the UK after the forthcoming election. They are based on the assumption that the incoming government will need to raise around £100 billion in tax rises and spending cuts in order to correct the fiscal deficit.

If – as the bookmakers expect – the new government is Conservative, the report predicts tax rises of £20 billion and spending cuts of £80 billion. It also shows that the fiscal consolidation is likely to be matched with an unprecedented monetary relaxation.

In general terms, the cebr assumes that the incoming government will need to get the budget deficit down to £50 billion by 2014/15. Without fiscal action the forecasts predict a deficit of £143 billion in that year.

However, the report shows that the strategy of getting the budget deficit down is likely to work and that growth over the 2009‐2014 period will average 1.4%. It also shows that growth is likely to dip in 2011 and 2012 as the budget cuts are absorbed. After that, says the cebr, the effects of the low interest rates and the weak pound should boost growth by encouraging investment, halting the rise in savings, boosting exports and restraining the growth of imports.

"We are likely to see an exciting policy mix, with the fiscal policy lever pulled right back while the monetary lever is fast forward," said Douglas McWilliams, one of the report's authors and Chief Executive at cebr. "Our analysis says that this ought to work. If it does so, we are likely to see a major rerating of equities and property which in turn should stimulate economic growth after a lag."

According to Charles Davis, Senior Economist at cebr, the scenario predicted by the study will be affected by unexpected changes in the world economy or inflation.

"Our forecasts show low levels of labour cost inflation which should keep the CPI [Consumer Prices Index] low enough to prevent the MPC [the Bank of England's Monetary Policy Committee] from having to raise rates until the economy is recovering," he said. "But this does require the prices of oil, primary commodities and food not to rise so fast that with a weak pound they dominate the impact of low labour costs."