MNI INSIGHT: BOE Papers: Demographics Low Rates Key; QE Doubts

-Upcoming BOE Working Paper Shows Ageing Can Explain Near Half Fall In Real

Interest Rates Since 1980

-Another BOE Working Paper Makes Case For Tightening Via QE Before Rate Hikes

By David Robinson

     LONDON (MNI) - Analysis by senior Bank of England economists, soon to be

published in two Bank working papers, highlights the key role ageing populations

are playing in driving down real interest rates and makes a case for tightening

via asset purchase policy before hiking the policy rate.

     The work on demographics adds flesh to the belief of BOE Monetary Policy

Committee member Gertjan Vlieghe that ageing populations could be having a large

downward effect on real interest rates, which Vlieghe used as part of his case

to be patient over monetary tightening as Bank Rate may not have far to rise. 

     The work on QE raises tricky questions over the MPC's approach to

synchronising Bank Rate hikes and QE unwind.

     The paper on demographics, by the BOE's Head of International Research

Gregory Thwaites and co-authors, concluded that ageing can explain about 160

basis points, about 45%, of the fall in advanced country real interest rates

since 1980 with 40 basis points still to come. 

     A key point is that the increase in the high wealth, older segment of the

population is set to continue, so the downward pressure on real rates will not

ease.

     An alternative view, supported by former MPC member Charles Goodhart and

others, is that an ageing population reduces labour supply and puts upward

pressure on wages and on real interest rates, but Thwaites' work highlights the

opposing effects, with ageing weighing on output and fuelling demand for

savings. 

     In the model Thwaites uses, the stock of wealth, rather than the flow of

saving, determines the interest rate and this stock falls only slowly during

retirement so dissaving by baby boomers does not push up much on interest rates.

     "It is true that the wealth of retired people will fall slightly as they

move through retirement. Offsetting that is the rise in life expectancy which

causes people who are currently in the labour force to try and save more because

they know they have to survive for longer," Thwaites said presenting his

research last week at the Money Macro and Finance (MMF) Research Group

conference at King's College, London.

     With real interest rates having fallen to unprecedented lows, Thwaites and

his team used a generational model to quantify the extent to which this could be

explained by population ageing, and they came up with the estimate that 45% of

it was due to ageing.

     They also found striking additional effects of population ageing. It can

explain much of the rise in the housing wealth to GDP ratio and "some labour

productivity slowdown from the 2000s."

     The paper looked at demographic trends across advanced economies. The

period 1970-1985 saw rapid growth among 20-24 years olds as the baby boomers

moved into the workforce, but the growth rate in this age group slowed after

that and even turned negative at times. At the same time longevity increased, so

retirement is becoming more prolonged and these effects look set to persist for

decades to come.

     Thwaites' model assumes households anticipate that they will live longer

and spend more time in retirement, and that they smooth consumption by

transferring more of their current wealth to the future and that these older

households continue to make up a large share of the populace.

     These two factors drive up aggregate savings to GDP and the interest rate

decreases to keep the capital market balanced in the face of higher capital

supply. An offsetting effect is that the lower interest rate encourages more

borrowing by younger people, pushing up on net household debt/GDP ratio.

     The dominant effect is that as older households have more assets and

account for a growing share of the populace this drives up the aggregate level

of savings per capita.

     On productivity, the assumption is that productivity is lower for young and

old workers so the atrophying of prime age workers helps partially explain lower

productivity.

     If real interest rates are going to stay low in part due demographics, this

feeds into the policy debate.

     When Vlieghe joined the MPC, he put the ageing population centre stage in

his first policy speech in January 2016 entitled Debt, Demographics and

Distribution of Income.

     Vlieghe said back then that "The economic effects of demographics are

clearly complex, but there are some persuasive arguments that suggest that the

combined effect might be to push down on real interest rates."

     One lesson Vlieghe drew was that it was plausible that the appropriate real

interest rate "might be very low for years to come. So policy rates, when they

rise, may not need to rise by much over the coming years. These medium-term

considerations make me relatively more patient before raising rates."

     Thwaites' work fleshes out Vlieghe's assumption by putting numbers of the

impact of the ageing population on real interest rates. 

     Another piece of research at the MMF conference was presented by Richard

Harrison, Senior Advisor - Monetary Assessment and Strategy Division, at the BOE

and a leading light in the Bank's analysis of policies adopted with the policy

rate at the zero bound, including on QE and forward guidance.

     His paper on Optimal Quantitative Easing, Harrison set out a case for

tightening firstly through the asset purchase programme and then through Bank

Rate, drawing similar conclusions from a different methodology to an ECB paper,

which was also presented at the MMF conference.

     On the face of it, this sits uneasily with the MPC's current approach of

leaving the stock of asset purchases unchanged until Bank Rate rises from its

current 0.25% to around 2%, a level it does not reach within the MPC's three

year forecast horizon.

     Harrison said, however, that if what matters is the stock of debt held by a

central bank as a share of the total debt stock then simply holding QE steady is

effective tightening.

     "We assume that government debt is fixed but in reality government debt has

been rising" and with "government debt rising the share that the Bank is holding

lessens," Harrison said.

     Asked by Market News International if his paper's conclusions were

compatible with the MPC's QE unwind policy Harrison said  "It depends what you

mean by unwind is the point I am making here. You could argue ... that what

matters is how much the central bank holds of the debt stock." 

     If "As long as the value of bonds held by the central bank is stable that

actually means through a no growth (in asset purchases) period policy is

tightening" and on this basis the model is consistent with the MPC approach,

Harrison said.

     If the total debt stock started to diminish and the MPC still held its

stg435 billion of Gilt purchases constant then any argument that it was

tightening would presumably be void.

     The Office for Budget Responsibility's forecasts show public sector net

debt in nominal terms peaking in the 2019-20 fiscal year, and as a share of GDP

in 2017-18, before trending downward. 

     The Thwaites and Harrison working papers are expected to come through the

BOE pipeline shortly. There is a currently a purdah period with the MPC meeting

this week and its policy announcement due out midday Thursday.

--MNI London Bureau; tel: +44 203-586-2223; email: david.robinson@marketnews.com

[TOPICS: M$B$$$,M$E$$$,MX$$$$,M$$BE$]