The interest rate shall in the short and medium term contribute to stable inflation and stable developments in production. At the same time, it shall in the long term also contribute to equilibrium in the market for real capital. Capital accumulation shall over time correspond to saving. To achieve this, the real interest rate must not over time deviate substantially from the return on real capital. Substantial deviations can give rise to undesirable fluctuations in the markets for real capital that have no basis in economic fundamentals. The economic situation varies over time. Monetary policy will set an interest rate that is alternately above and below the neutral rate. Consequently, the interest rate level will probably not deviate substantially from the long-term equilibrium rate over time. By taking a gradualist approach to interest rate setting, it is also possible to assess whether imbalances are developing in capital markets. Interest rate developments from a historical perspective In the long term, the equilibrium real interest rate will be determined by underlying structural relationships in the economy. These relationships will probably only be changed gradually so that changes in nominal rates will primarily reflect changes in expected inflation. In the short term, however, the real interest rate will vary, not least because monetary policy seeks to influence the real interest rate in the short and medium term. Changes in nominal interest rates might therefore reflect changes in both real interest rates and inflation expectations.
This could at one level be influenced by the fact that significant increases in housing wealth in recent years may have postponed people’s consideration of these issues, though they may now feel more pressing looking ahead. It is pretty clear that the changes are likely to be spread over a period of years, and from that perspective policy implications are likely to be gradual and manageable. Over time though the degree of change in savings habits – and therefore the impact on consumption and demand – may be quite significant. And the question is whether these changes will be smooth trends, or whether there will be more sudden, and perhaps unpredictable shifts or discontinuities in behaviour. And if the latter, will they be of sufficient magnitude to be relevant to shorter-term monetary policy? The challenges here are considerable, both of measurement, timing, and of our ability to anticipate any relevant changes. But to my mind we certainly need to remain alert. Policy makers in Germany have for some time now wondered if the sluggish performance of domestic demand in recent years is in part the result of such precautionary saving, and here in the UK we have wondered if this could have been one factor in the recent consumption slowdown. While the data will not confirm this for a while at least, the greater public awareness of the issues, brought about by initiatives such as Lord Turner’s report, suggests it is plausible that this has been a contributory factor.