UK: Why the Neutral Interest Rate Will Stay Structurally Low

Trying to predict the direction and exact timing of short-term interest rates this year has proved futile. In recent years, the concept of the "neutral interest rate" has become a focal point in economic discussions, particularly in the context of monetary policy. This rate, which represents the equilibrium where monetary policy is neither stimulative nor restrictive, is crucial in guiding central banks like the Bank of England (BoE). According to an analysis by Oxford Economics, the UK neutral interest rate has seen fluctuations recently but is expected to remain structurally low in the long term. This projection is informed by several economic factors, primarily inflation expectations, demographic changes, and productivity trends.

Recent Trends in the Neutral Interest Rate

Oxford Economics estimates that the UK neutral interest rate has risen recently to just below 3%. However, this increase is projected to be temporary, with the nominal neutral rate expected to fall back to around 2% by 2030. Inflation expectations are the primary driver behind this recent rise and the anticipated decline. The significant increase in inflation due to the pandemic, geopolitical events like Russia's invasion of Ukraine, and substantial pay growth have temporarily pushed up the nominal neutral rate. As these inflationary pressures subside, the structural forces that have kept interest rates low since the 1980s will likely reassert themselves, preventing a return to the higher rates seen before the global financial crisis.

Long-Run Real Neutral Rate

Stripping out inflation expectations reveals a more modest increase in the real neutral rate over recent years. The actual neutral rate adjusts for inflation and is expected to remain historically low due to weak demographic and productivity prospects. This rate is crucial because it better reflects the underlying economic conditions without the distortions caused by fluctuating inflation expectations.

Demographic and Productivity Challenges

The UK's demographic trends significantly impact the neutral interest rate. Improvements in longevity have outpaced increases in retirement age, leading to a higher need for retirement savings and a consequent increase in the supply of capital. Simultaneously, declining birth rates reduce the number of young households demanding loans, thus decreasing the demand for capital. These demographic shifts result in a lower neutral rate.

Furthermore, the UK's productivity growth has been sluggish over the past two decades, exacerbated by events like the global financial crisis and Brexit. This weak productivity growth depresses the neutral rate by reducing potential output growth and investment returns and limiting wage growth and borrowing capacity for younger households. While there is some potential for a recovery in productivity, driven by advances in technology and artificial intelligence, these improvements are expected to provide only limited support to the neutral rate in the foreseeable future.

Structural Forces Influencing the Neutral Rate

Several structural forces have historically influenced the neutral rate, and they continue to do so. Rising government debt, for instance, has been a significant factor pushing up the neutral rate. Public sector net debt in the UK has increased substantially, particularly after the global financial crisis and the pandemic, which has heightened the demand for capital and supported aggregate economic demand.

Quantitative easing (QE) programmes, where the BoE purchased government bonds, have also played a role. While QE initially depressed the neutral rate by increasing the supply of capital, the start of quantitative tightening is now beginning to reverse this effect.

Future Projections and Uncertainty

Oxford Economics projects that the long-run nominal neutral rate will stabilise around 2% by 2030, driven by the normalisation of inflation expectations. However, these estimates have significant uncertainties, particularly for small open economies like the UK, which are more susceptible to international developments. Despite these uncertainties, demographic trends provide a relatively reliable long-term outlook since they are determined by birth rates and longevity patterns established decades in advance.

Scenario Analysis

Oxford Economics conducted various scenario analyses to explore potential deviations from their baseline projections. For instance, higher government debt scenarios, increased net migration, improved productivity growth, and further increases in the retirement age all suggest that while these factors could push the neutral rate higher, they are unlikely to result in a substantial or sustained increase.

In conclusion, while recent inflationary pressures have temporarily elevated the UK neutral interest rate, the underlying structural forces - particularly demographic changes and productivity trends - point towards a return to a structurally low neutral rate. Understanding these dynamics is crucial for policymakers, long term investors, and the broader public as the BoE navigates its monetary policy decisions in the coming years.

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