According to the Bank of England, economists assume interest rates will rise and move toward equilibrium or a ‘natural’ real rate of interest that takes into account inflation over the long term.
The idea of a natural rate of interest was first introduced by Swedish Economist Knut Wicksell. Recognised as an economist’s economist in the late 1800s and early 1900s, Wicksell is known for his macroeconomic text Interest and Prices which noted the difference between the real rate of return on capital (aka: the natural rate of interest) and the market rate of interest (aka: the rate borrowers pay). According to The Economist:
“If the financial rate is below the natural rate, businesses can reap unlimited profits by borrowing as much as they can and ploughing it into high-returning projects. Eventually, though, all that additional spending pushes up prices, money and credit, and eventually, financial interest rates.
Wicksell saw financial rates as those set by banks competing to make loans. That job is now performed by central banks. They still think in Wicksellian terms: the natural rate prevails when the economy is at full employment. Set the policy rate above the natural rate and the economy tips into depression. Set it below, and inflation results – or, some worry, speculative credit booms.”
So, where are interest rates headed? According to the Bank of England’s report this month, as it upgraded its UK growth forecasts and said unemployment would fall “faster than anticipated”.
Business surveys suggest Britain is now enjoying a “robust recovery in activity” and the jobs market is improving, according to the minutes to this month’s Monetary Policy Committee (MPC) meeting.
In the minutes, the Bank noted that strong business activity surveys, improving employment intentions, and a fall in the claimant count suggested unemployment “would fall further over the rest of the year, probably at a faster pace than anticipated at the time of the August Inflation Report”.
Source: Bank of England & Telegraph