Reduction in risk appetite among investors since the financial crisis explains why UK interest rates are likely to remain below pre-crisis norms for many years, according to the Bank of England’s David Miles.
In a speech at Queen Mary College in London, Mr Miles, a member of the bank’s Monetary Policy Committee, gave the clearest explanation yet of why the BoE expects long-term interest rates to remain at about 3 per cent, rather than returning to the pre-crisis average of 5 per cent.
He proposed that the neutral bank rate – defined as a level which keeps demand in-line with supply and inflation at target – is a combination of average real return to investors on safe assets and the inflation target.
Historically, the return on safe assets has averaged 3 per cent, which combined with an inflation target of 2 per cent equates to an equilibrium rate of 5 per cent – which, Mr Miles added, has been the average rate level over the 320 years since the founding of the BoE.
But since the crisis the level of return required by investors on “safe assets”, such as government bonds, has fallen as investors become more risk adverse and value surety over high returns, potentially reducing the return by 1.5-2 per cent for an extending period, according to Mr Miles.
Mr Miles said: “Households, firms, and investors now attach a higher probability to financial crises and sharp, prolonged downturns in economic activity: events that many may have thought close to inconceivable. This makes assets which generate a real return with little risk more attractive, driving down the real risk-free interest rate. It also makes the wedge between safe rates and the rates of return required on riskier assets greater. Those forces will tend to reduce the neutral level of the policy rate set by the central bank.”
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