Bank of England: the risk of ‘zero interest rates’

Author: | Published: 23 May 2013
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Interview transcript

Q: What is the risk to financial stability of an extended period of 'zero interest rates'?

"This bears some very careful watching. Interest rates are where they are for a reason, which is to try and stipulate spending, stimulate nominal demand. But in doing that, it's tremendously important that we are wide-awake to the potentially adverse unintended consequences of interest rates being where they are. What might those consequences be? One might be that many institutional investors rely on the yields on long-term assets to meet their liabilities. So, if you're a pension fund or an insurance company and you've guaranteed a return to those that invest in you, it's harder to make that return if global long-term interest rates are very close to zero. Think through what are the consequence therefore for pension funds and insurance companies –

Another risk that gets posed is that people are somewhat immunized to interest rate risk. They stop thinking about it actively. They stop managing it actively. And therefore they end up taking on too much interest rate risk because they think it's gone away. That's a second risk that we should care about a lot. And the reason we should care about that is that we cannot guarantee interest rates will be where they are for the next 10,15,20 years and should they spike up for whatever reason we need to ensure that our financial system has hedged itself adequately against that risk. Otherwise we have a very nasty situation where yields have picked up, asset prices start falling, risk starts to be shipped onto the balance sheet of our major banks or financial institutions and we find ourselves in a much gloomier situation than we would want to be

That interest rate risk is something we have to be very vigilant to as regulators when figuring out what might go wrong tomorrow which is, after all what we're all paid to do.

03.05 Q: Do 'zero interest rates' cause macroeconomic tension to build up elsewhere?

There is certainly something of a - call it a tension; call it an unintended consequence of some of the action that has been taken. Let's be clear, the action has been deliberately with an eye to stimulating risk taking, to boosting asset prices. That's what's it's there to do, that was its purpose but sometimes with policy, in life you can overachieve and we need to be conscious of overachieving, of stimulating too much risk, of overinflating asset prices, of setting in train just the sorts of leveraged bubble that led to this crisis in the first place. If nothing else, we must must must not repeat the errors of the past.

04.13 Q: What happens when central banks start their exit strategies?

It's tricky to answer that in the abstract. I think in the US, it's already been made clear that they would hope to do this in as orderly and sequenced a way as possible so as to take the market unawares so as not to bring about jerky movement in interest rates. So I think we as central banks will be duty bound to do this in a way that minimises shock, minimises surprise, that enables the market to adjust to that new world – whatever it is – in a way that leans against those risks I just spoke about and that's what we'll do.

05.20 Q: When interest rates start to normalize will capital that has been flooding into alternative investment channels flood back out again?

So, as I mentioned we need to be super vigilant that markets don't get ahead of themselves, don't become too bubbly, too frothy, their prices don't become too rich. Now that always happens a bit – it's in the nature of financial markets that pockets get bubbly for a bit. And part of me thinks so what? If they fall to earth, then people who've put on the bets are slightly less rich than they might otherwise be. That by itself, isn't a problem. When it becomes a problem, is if those bets are unpinned by the banking system, they're underpinned by leverage. Then when the bubble goes pop, the banks go pop with it and that's the risk we need to watch out for really. Which is not bubbles per se – which will always be with us, we've had bubbles as long as we've had financial markets – but those bubbles that are pernicious are those that track back to the banking system and risk blowing it up. At present, there's very few signs of the bubbly behaviour in the markets being underpinned by the banking system so in that sense, let a thousand bubbles be blown. If that was the case, then we as macro prudential regulators might want to step in and prevent that collateral damage to the banking system taking hold.

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