Governor of the Bank of England's message to financial markets

Mervyn's message to financial markets
Published: January 18 2006 02:00 | Last updated: January 18 2006 02:00

A great debate is under way that seeks to explain the central economic problem of our time: why is money so cheap? Or, to use more technical language, why are long-term real interest rates so low? The fortunes of millions rest in no small measure on the answer to this question. Alan Greenspan, the outgoing chairman of the Federal Reserve, famously described it as a "conundrum". Ben Bernanke, the incoming Fed chief, put forward one possible explanation: a "global savings glut". Now Mervyn King, the governor of the Bank of England, has set out his thinking in an important speech.

Mr. King puts the interest rate puzzle in the context of a series of changes in relative prices. The relative price of labor-intensive goods has fallen, the relative price of energy has risen and the cost of money has fallen sharply, even after allowing for changes in expected inflation. The first two developments are logical consequences of integrating China and India into the world economy. But the fall in the price of money is harder to rationalize.

The governor highlights two possible explanations. One is the global savings glut favored by Mr Bernanke, which can be rephrased, with different emphasis, as a shortage of desired global investment. The other is excess liquidity, stemming in part from a long period of very low short-term interest rates around the world, which has flooded into asset markets and driven down risk premiums. Whichever explanation is right (and the two are not unrelated) these conditions are unlikely to persist forever. At some point, Asia will consume more and save less, while investment is likely to pick up. Equally, asset prices cannot continue to rise indefinitely, relative to the incomes they generate, andare likely to revert to more normal multiples.

The adjustment process, when and if it comes, is likely to be a turbulent one, with spillover effects from asset markets to consumer prices and the real economy. The private sector should not overestimate the ability of central bankers to steer a smooth course through it. Worryingly, markets appear to be assuming that - with the Fed approaching the end of its rate tightening cycle - the worst is already over. In reality, it has not even begun.

If Mr. King is right, what follows? Businesses should raise capital while it is cheap. Investors should demand adequate risk premiums. Pension funds should not rush into bonds, even if it makes sense in the long run for them to rebalance their portfolios.

UK real long-term rates are even lower than elsewhere in the world:0.9 per cent for 30-year index-linked gilts. Given this, the Treasury should refinance existing debt and shift to longer index-linked maturities, as Willem Buiter proposed in the FT on Monday. This would benefit taxpayers, and may ease the pension fund dilemma. It should be considered without delay.

Copyright by the Financial Times