• Typically, nominal interest rates are 1 - 2 % higher than inflation.
• As inflation rises, interest rates rise to reduce inflationary pressure. As inflation falls, interest rates can be reduced to boost economic growth.
• 2008 has seen negative real interest rates.
  

This year has seen an unusually fast cut in interest rates. Using CPI inflation (which I still feel is best guide to effective inflation) real interest rates have become negative. i.e nominal interest rates are less than the inflation rate. (interest rates 0.25%, CPI inflation 3%)

Typically, a cut in interest rates of this magnitude would cause inflation. However, certain factors have meant that the current interest rate cuts have been ineffective. In fact, many economists still expect CPI inflation to fall in coming months.

Worried by the extent of the recession, the Monetary authorities have even resorted to unorthodox methods to boost money supply.

But, why have interest rate cuts been ineffective in boosting economic growth?

• Extent of the downturn. The recession has been so sharp, that investment and consumption have fallen dramatically and so the cuts in interest rates have only mitigated the extent of the downturn
• House Price falls provide a powerful negative impact on spending. Lower interest rates should boost spending. But, with house prices falling 20% since the peak, this has reduce consumer wealth and therefore reduced spending.
• Global downturn. Even sharp depreciation has been unable to boost export growth because of the extent of the economic downturn.
• Time Lag. There are tentatative signs of economic recovery (manufacturing data showing improvements, rise in mortgage lending, fall in house price slowed) e.t.c. Therefore, we may expect the economy to recover quicker than expected and in due course, we may see a return of inflation. With quantitative easing this may appear sooner than expected.

Outlook for Next 12 Months

My feeling is that over the next 6-12 months we will increasingly see the various policies (interest rate cuts, QE, fiscal policy, weak sterling) all help the economy to recover. I think the government and monetary authorities have done enough to avoid CPI deflation. It is always difficult to predict, but, the worst falls in GDP may have passed. Economies in the Eurozone may take longer to recover because of their greater reluctance to embrace expansionary policies.

It is quite feasible in the next 12 months, interest rates could shoot up quickly to over 5% to deal with the inflationary impact of QE combined with economic recovery.

Chart Showing Inflation and Domestic Demand
Consumer Expenditure deflator is effectively inflation rate.

• When inflation is higher than nominal domestic demand, it means real demand is falling.

Related

• Does low inflation always mean low interest rates?
• Real Interest rates
• Understanding interest rates