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  • Writer's pictureWilliam Webster

Why are interest rates so low?

In the UK, Bank rate is 0.50% this is the lowest it has ever been since records began over 300 years ago. According to many economists this is the worst economic period since the 1930s. Wages haven't kept up with prices and real incomes have declined. Policy makers explain their fear of a "double dip" and all the problems that deflation can bring. Every time there is a hint of a rate increase voices say it will damage any hope of recovery. Isn't there something very puzzling here? We aren't taking about putting rates up from 5% to 6%, just 0.5% to 0.75% or maybe 1%. Perhaps we are missing something. Is it that rates are so low because bank balance sheets are still in a mess? It's a well known fact that as a result of leverage bank capitalisation is far lower than ideal. This can be resolved via a combination of retrenchment, earnings and equity. For the highly leveraged bank cheap money is just what's needed. It allows you to earn more through carry and wider margins. This eventually recapitalises the balance sheet at no cost to the taxpayer so it's politically more acceptable. That's unless you are a saver. If the strength of bank balance sheets gives you some insight into how long it will take rates to normalise it's going to be some time yet. There is just one problem. Running interest rates this low hasn’t been tried before. Combined with QE could it lead to unknown consequences? It's quite clear that the inflation target has been allowed to drift. If higher wage demands eventually result then the central bank will be required to act even if it's just to preserve its own credibility. The permutations of scenarios are infinite. So if you do run a bank balance sheet enjoy the carry. But do keep a close eye on interest rate risk on the trading desk and in the banking book. It could be the latter that causes pain in the future.

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