Bank of England Governor Mark Carney has suggested that a “normal” level of Bank rate is now about 2.5% versus 5% before the financial crisis. This suggestion is defensible based on the recent spread between bank interest rates and Bank rate – this has been much higher than before the crisis, requiring Bank rate to be lower to compensate. The spread, however, is now on a falling trend. This suggests that 1) a rise in Bank rate is overdue and 2) the “new normal” for Bank rate may be 3.5-4% rather than 2.5%.

Changes in bank deposit and lending rates are a key part of the transmission mechanism from MPC decisions about Bank rate to the economy. In the 10 years up to Lehman’s bankruptcy in September 2008, the interest rate on the stock of bank lending to households was 2.0 percentage points (pp) above Bank rate on average, while the rate on household deposits was 1.3 pp below it*. The deposit rate moved above Bank rate during the crisis and has remained significantly higher since, while the lending rate / Bank rate spread roughly doubled from its earlier level – see first chart.


These changes can be summarized by comparing an average of the household lending and deposit rates with Bank rate. The spread between this combined household interest rate and Bank rate was 0.3 pp on average in the 10 years up to Lehman’s bankruptcy but has been 2.4 pp since – second chart.


The rise in bank interest rates relative to Bank rate implies that a given level of official rates now is equivalent, in terms of economic impact, to a much higher setting before the crisis. A simple way of comparing the two periods is to subtract the pre-crisis average spread from the combined household interest rate in each month since September 2008. The resulting series can be considered to be an “effective” level of Bank rate based on pre-crisis conditions – third chart.


This effective rate fell by much less than actual Bank rate after the crisis, averaging 2.7% since September 2008. It has, however, declined from 2.7% to 2.2% since late 2012. This reduction reflects Bank of England / ECB measures to lower funding costs, as well as banks’ efforts to strengthen their finances, which have resulted in a lower credit risk premium on their borrowing.

The current effective rate of 2.2% is 2.8 pp below Mr Carney’s 5% estimate of the “normal” level of Bank rate before the crisis. Put differently, assuming no further change in the spread between bank interest rates and Bank rate, the latter would need to rise by 2.8 pp to achieve the same economic impact as a 5% level before the crisis. On this assumption, the “new normal” for Bank rate is 3.3%** (i.e. the actual 0.5% rate plus 2.8 pp).

The decline in the spread between bank interest rates and Bank rate, however, may extend. Rates on new time deposits and fixed-rate mortgage lending are currently 0.3 pp and 0.4 pp respectively below those on the outstanding stocks, suggesting a decline in the outstanding rates as existing business matures and is replaced. Wholesale funding costs, meanwhile, may ease further as banks add to their capital buffers; the ECB’s forthcoming TLTRO operations may have an additional helpful impact. Assuming, conservatively, a 0.5 pp reduction in the spread, the effective level of Bank rate, based on a 0.5% actual rate, will move down to 1.7%. This, in turn, would imply that actual Bank rate would need to rise to 3.8% to be consistent with the “old normal” of 5%.

The decline in bank lending and deposit rates since late 2012 suggests that the MPC should already have started to raise Bank rate. The level of bank interest rates in late 2012 was sufficiently stimulatory to generate strong growth and a rapid erosion of economic slack in 2013. The 0.5 pp fall since then represents an unwarranted additional loosening of monetary conditions. Bank rate, in other words, needs to be raised by 0.5 pp immediately simply to return its effective level back to late 2012; a larger increase would be required to effect a tightening of policy.

*January 1999 to September 2008 inclusive. Lending / deposit rates on outstanding stocks estimated from Bank of England rate / volume data for different types of business.
**Mr Carney’s estimate of a “new normal” of 2.5% may be based on the average post-crisis bank interest rate / Bank rate spread rather than the current level; it may also incorporate a judgement that the economy faces additional medium-term headwinds, e.g. from fiscal tightening, an overhang of household debt and Eurozone weakness – see the report of his BBC interview on 27 June.