In the August 2018 Inflation Report, the MPC set out its framework for thinking about the equilibrium interest rate, which is also described in further detail in a background paper coauthored with Bank staff that will be published alongside this speech. [3] That framework decomposes the equilibrium real interest rate, sometimes called r*, into the sum of two components. The first component, called the ‘trend real rate’ or upper-case R* for short, is driven by long-term structural factors. The second component of (lower-case) r* reflects the effects of cyclical shocks to both aggregate demand and supply and so can vary substantially over the short to medium term. [4] My focus today is on the structural narrative that shapes the policy landscape in the long run. Accordingly, I will look at the trend real rate (upper-case R*) and in particular at its determinants at the global level over the past sixty years or so. For an open economy like the United Kingdom, the trend real rate is pinned down by global forces; as capital is free to move around the world, interest rates would depend on the balance of savings and investment in other countries as well as the United Kingdom. Global R* thus acts as a long-term anchor for the UK’s domestic equilibrium real interest rate. Understanding the relative importance of the different secular factors that drive Global R*, therefore, sheds light on the forces that may ultimately shape the evolution of domestic real interest rates.
If we are to prevent another crisis, action is required on both of the fundamental causes. First, we need to resolve the problems caused by massive capital flows from poor to rich countries. Yet the imbalances are growing again. This problem can be tackled only by international cooperation – most obviously through the G20 – and I hope that the trade union movement will continue to engage with that process. Second, our financial system needs radical reform. Slowly but surely, we must move towards a banking system that does not put both the economy and your members’ livelihoods at risk. In the long run, banks will have to hold much more capital and be much less highly leveraged. Part of the answer is improving the way we regulate banks, and devising policy tools to control the risks taken by the financial system as a whole. The aim should not be to prevent all bank failures. Just as with every other company in the economy, banks that get it wrong must be allowed to fail, without risk to ordinary depositors or taxpayers. In 2008, banks were bailed out not to protect them but to protect the rest of the economy from the banks. That may not seem fair – and it isn’t – when other companies, such as Jaguar, had to stand on their own feet or go to the wall. So banks too must face market discipline. But we need to do more than reform our banking system.