The required return on investment is reduced at a lower interest rate at the same time as saving is less profitable. ii. Interest rate changes also have an income effect through interest income and interest expenditure on existing assets and liabilities. iii. Interest rate changes also affect share prices and real estate prices – lower interest rates increase demand for shares and properties and prices increase. An interest rate reduction also affects household wealth through higher share and property prices which in turn affect consumption decisions. The interest rate channel therefore affects demand for goods and services and thus the output gap with some time lag through many complicated mechanisms. Changes in the use of resources or the output gap then affect inflation in turn, with some time lag. The impact of changes in the instrumental rate on demand and inflation may also be affected by the lending rate set by the banks. The channel that is mediated by the behaviour of the banks can be generally referred to as the credit channel. Higher interest rates may, for instance, reduce the willingness of the general public to keep funds deposited in current accounts, which have a very low return. Deposits have a very low financing cost for the banks and if they have to finance an increased proportion of their lending in another way, the banks may compensate for this by a higher lending rate. 2 However, it is uncertain how the behaviour of the banks affects the impact of monetary policy.
These indicators clearly have an important bearing on macro-economic health: among workers whose disposable incomes have fallen materially below their pre-crisis levels; among savers, the rates of return on whose assets have fallen materially below their precrisis levels and are near-zero in inflation-adjusted terms; and among companies, whose underlying efficiency has flat-lined since the crisis. These trends are also closely linked. Weak productivity has constrained UK companies’ ability to pay higher wages, such that productivity and real wages have fallen in lockstep since 2008 (Chart 3). And this combination of a weak supply side and weak pricing pressures has in turn generated the need for low or negative real interest rates. To give these developments some context, consider a simple index of real wages, real interest rates and productivity growth. Given their recent trends, and with an eye to semantic symmetry, let’s call this an “agony index”. Charts 4 and 5 plot this agony index from 1970 and back to 1870. The agony index is currently at painfully low levels.5 It has been around 5 percentage points below its 1970–2014 average since 2008. Such an extended period of agony is virtually unprecedented going back to the late 1800s, with the exception of the aftermath of the World Wars and the early 1970s. So far, then, so bad. On this evidence, the UK economy is as weak as at any time in the recent or distant past. It is firmly on the back foot.