Bank of England Governor Mark Carney last week suggested that the MPC will consider a rise in Bank rate “around the turn of this year” and that increases will “proceed slowly ... to a level in the medium term that is perhaps about half as high as historical averages". Mr Carney claimed that the pre-crisis average level of rates when inflation was at target was around 4.5%, so "half as high" implies a "new normal" of about 2.25%. Even if he is correct, however, the tendency of rates to cycle around their normal level suggests a future peak significantly above 2.25%. The latter level, moreover, seems implausibly low.

Mr Carney’s remarks have been widely interpreted as signalling a peak level of rates no higher than 2.25%. This assumes that the MPC will be able to calibrate the timing and extent of policy tightening in order to keep actual rates in line with their recovering normal level, consistent with achieving the inflation target. Such a perfect glide path is highly unlikely to be achieved given uncertainty about the correct inflation “model”, imperfect information about the current state of the economy and “shocks”. Historically, rates have rarely, if ever, increased slowly to an extended plateau. They have, instead, tended to rise abruptly to a short-lived peak. The process of reaching the normal or equilibrium level, in other words, has involved an overshoot and correction.

There were five rate rise episodes between the start of inflation targeting in October 1992 and the onset of the financial crisis in late 2007. Bank rate peaked at 6.625%, 7.5%, 6.0%, 4.75% and 5.75%. The mean deviation from Mr Carney’s estimate of a pre-crisis equilibrium rate of 4.5% was 1.625 percentage points (pp). If the “new normal” is 2.25%, therefore, it would be reasonable to expect rates to overshoot temporarily to 3.75-4.0%.

The minimum deviation from Mr Carney’s “old normal” was 0.25 pp in 2004 but rates were subsequently reduced by only 0.25 pp before embarking on another sustained rise to 5.75%. Even in the one case when rate rises stopped around the supposed equilibrium level, therefore, a substantial further increase ensued.

Mr Carney’s estimates of old and new normals of 4.5% and 2.25% respectively, meanwhile, seem low. He claims that 4.5% was the average level of rates during the pre-crisis period when inflation was at target. In fact, inflation was exactly equal to the central objective between the start of targeting and the onset of the financial crisis, while Bank rate averaged 5.4%, not 4.5%, over this period*.

Why should the new normal be 2.25 pp below the old? Mr Carney mentions headwinds to growth and inflation from global economic weakness, sterling appreciation and fiscal tightening. Such restraints, however, are temporary – they warrant proceeding slowly with rises but do not imply that the long-run equilibrium level of rates will be lower than in the past.

The main reason for believing that the new normal is significantly lower, unmentioned by Mr Carney, is a changed relationship between bank interest rates and Bank rate since the crisis. For example, the average bank interest rate vis-à-vis households** is now 2.0 pp above Bank rate versus an average premium of only 0.3 pp in the nine years to end-2007 – see chart. This suggests that a given Bank rate now has the same impact on household economic behaviour as a level 1.7 pp higher before the crisis.

Assuming that the spread between bank interest rates and Bank rate remains at its current level, an old normal of 4.5% may, therefore, imply a new normal of about 2.75% rather than Mr Carney’s 2.25%. If the old normal was 5.4%, however, the suggested new equilibrium is about 3.75%. These estimates, of course, will increase if the spread between bank interest rates and Bank rate continues to trend lower.

*The target was initially expressed in terms of RPIX inflation, with a central objective of 2.5%, but was switched to CPI inflation at end-2003, with a 2% goal. RPIX inflation averaged 2.5% over 1994-2003 while CPI inflation averaged 2.0% over 2004-07.
**Average of lending and deposit rates.