Negative Real Interest Rates

Readers Question: What Happens when Inflation is Higher than Interest Rates?

Amidst all the talk of spending cuts, budget deficits and double dip recession, a curious feature of the UK economy is that (unlike other OECD economies) we have inflation significantly higher than base interest rates.

As of September 2010, CPI inflation is 3.1%. Bank of England Base interest rates are 0.5%

In theory, this means that if you are saving money at the Bank of England base rate, your money is devaluing. The interest on your savings will be insufficient to meet the increased cost of living.
This is bad news for those who rely on savings, such as pensioners.

In theory, negative real interest rates should encourage people to spend as there is no point spending. However, evidence suggests that people may actually be putting more effort into saving because returns are so low. (basically income effect is outweighing substitution effect) People feel they need to save more because of the low interest payments on savings. It is like the paradox of thrift but for saving.

Also, it is worth remembering that banks may have commercial rates different to the Bank’s base rate. Many banks are offering saving rates considerably higher than base rates to attract deposits. Therefore, if you look around, you may be able to maintain the value of your savings, – but only just.

The other perspective is that this should be good for borrowers. Inflation is eroding the value of debts, but, interest payments are going to be low. But, again banks may have interest rates different to base rates.

Why Don’t Bank of England Raise Interest Rates?

With a negative real interest rate, it seems to make sense to increase interest rates. However, there are other issues. The UK economy is slowly emerging from a long recession. Spending cuts threaten to slow growth and lead to more unemployment. Though negative real interest rates are bad for savers, other people in the economy are experiencing greater financial difficulty – such as the extra one million unemployed. To increase interest rates may be good for savers, but, it would be damaging to the rest of the UK economy.

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