Outlook for Monetary Policy – July 2010

There is speculation about how long interest rates will stay at zero. – See: – How long will interest rates stay at zero?

Another issue is the limitations of zero interest rates. There is much hope / expectations that fiscal austerity can be offset by loose monetary policy – i.e. if we cut government spending and increase tax, then as long as interest rates are low, AD and economic growth will continue to increase. However, if we still face very low confidence, shortage of money in credit markets – a liquidity trap, then loose monetary policy may still be insufficient to avoid a slow down in the economy.

Of less importance is the potential side effects of prolonged low interest rates. This is particularly a problem for the UK where we have zero interest rates but quite high inflation. This means real interest rates are negative. In theory, this is bad news for savers and good news for borrowers (like the government)

Also, prolonged zero interest rates could in theory create a boom in borrowing, a boom in asset prices like the housing market. However, practical conditions suggest this looks very unlikely. If anything, UK house prices look precarious. I can’t see any banks willing to lend mortgages freely to every Tom, Dick and Harry. An asset bubble is a theoretical problem, but, it’s not what we should be worrying about now.


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