There are always many rates of interest quoted by banks both for savers and for borrowers. For savers there are low or zero interest current accounts, and savings accounts of varying periods, the longer the duration the higher the interest. For borrowers the interest is generally much higher than for savers, and varies according to creditworthiness and availability of collateral. There are also non-bank lending companies that also quote various rates.
All these rates are available in the lending market - market rates - and what matters to everyone in the real economy is not the rate that is quoted but the rate relative to inflation. For example if a quoted rate is 5% per year when inflation is running at 2% per year, then the rate relative to inflation is 5% - 2% = 3%.[189] The rate relative to inflation is known as the real rate, and the quoted rate is known as the nominal rate. The terms 'real' and 'nominal' have these same meanings in many contexts in economics.
What is the ideal interest rate? Is there one? Economics normally regards the lending market as any other market, supply being provided by banks and other lenders and demand being provided by borrowers. The interest is the 'price' of money set by the relative strengths of supply and demand. But as discussed in the next chapter the lending market is very different to other markets because banks don't lend something that already exists, they create new money in exchange for loan agreements and destroy it on repayment. Because of this there is a strong positive feedback mechanism that makes the supply of money unstable, with accelerating lending and borrowing during times of economic growth and the reverse during economic decline.
The BoE attempts to regulate interest rates by varying the interest (known as Bank Base Rate or Bank Rate) that is charged to banks for borrowing BoE reserves, the theory being that the less banks have to pay for reserves the less they charge to borrowers and pay to savers, and vice versa. The target that the BoE tries to maintain is an inflation rate of 2% plus or minus 1%. If inflation rises or threatens to rise above 3%, then the bank rate is raised to raise the cost of bank borrowing with the hope of raising the cost of customer borrowing and the expectation that the money supply will drop as a result. The opposite is the case if inflation drops below 1%. The theory is that inflation only rises when there is too much money for the economy to absorb in expansion - see chapter 18, and that inflation only falls to low levels when too little money is in danger of shrinking the economy - see chapter 16.
At best the bank rate is a very crude device with which to control the economy, and inflation is not always an appropriate target as it can be caused by commodity price changes on the world market as well as by the quantity of money - recall the oil price spike in 1973 that pushed almost all prices up massively. Also when the bank rate is very low as it is now, there is no further it can fall, so this as a control measure ceases to be effective, requiring other more desperate measures to be applied such as quantitative easing. Government and BoE control measures and their effectiveness are discussed in more detail in chapter 86.
Knut Wicksell, a leading Swedish economist argued persuasively that the natural rate of interest is equal to the overall return on wealth-creating capital - the rate of new wealth created per unit wealth invested (Wicksell 1936). This is not to be confused with economic growth which is the rate of change of aggregate wealth creation within the economy - see chapter 97.
The logic is as follows: If the loan rate for borrowers is less than the natural rate then investors can profit by borrowing to invest in production - sufficiently high returns are generated both to pay back the loan and also enjoy a profit. The investment first absorbs spare capacity, which is desirable, then competes for existing labour by raising wages and also prices (as far as competition will allow) to pay the increased wages, causing inflation, which is undesirable. However two countering effects soon materialise. Firstly, with more borrowers seeking funds banks are able to make more profit by raising interest rates. Secondly, if the inflationary stage is reached at full employment the cost of production rises because of the need for higher wages as staff have to be tempted away from other employment, and competition limits the ability to raise prices to the same extent, so the rate of return on capital drops. The net effect is that if the rate of interest to borrowers is below the natural rate then the tendency is for interest rates to rise and, at full employment, the return on capital to fall, until they equalise at the natural rate.[190] Low interest rates are good for taking up spare capacity but bad when there is full employment. They are also bad in that they foster inefficiency by allowing poorly run industries to remain viable when the health of the economy is best served when industries have to maintain high levels of efficiency.
Conversely if the interest rate is higher than the natural rate then this will have a depressing effect on the economy as money that would have been used for productive investment is saved instead because it provides a better return. In these circumstances businesses don't expand, new businesses aren't set up, uncompetitive existing businesses fail for lack of investment in maintaining production, spare capacity builds up as people become unemployed, wages and prices fall as demand drops, and the value of money rises threatening deflation. At the same time the number of borrowers falls so banks reduce the interest rate. The effects, while the high interest rate lasts, are bad for the economy, but hopefully before it becomes too serious the effect of decreasing numbers of borrowers causes the rate of interest to fall back towards the natural rate.
Therefore in stable conditions the rate of interest should remain at or close to the natural rate, with a slightly higher rate for borrowers to encourage investment in businesses that are better than average so as to promote an improving trend, and a slightly lower rate for savers to discourage saving in preference to wealth generating investment. The natural rate is therefore that which achieves stable prices, and the aim is to achieve stable prices at full employment.
This is a very well argued and convincing theory, but, to achieve stability it depends on 'all other things remaining the same' (ceteris paribus in economic jargon), which they never do (ceterisn't paribus!) Banks create and destroy money, governments tax, borrow and spend, imports and exports rise and fall, natural disasters occur, confidence in the future waxes and wanes, so stability is never achieved. Therefore both the impact and the direction of all these things and more must be estimated in any attempt to predict what the economy will do in any set of circumstances, and the interest rate is just one of a number of factors that have influence. In the face of all this the BoE's two control parameters - bank rate and open market operations (buying and selling bonds on the open market), together with its single target - inflation rate, are very unlikely ever to be sufficient to control the economy in any but the most benign circumstances, and in crises they are seen to be woefully inadequate - see chapter 86.
Nevertheless Wicksell's 'natural rate' remains as good a target as we are likely to get for the prevailing rate of interest for ordinary borrowers and savers, and when rates are well out of line with it we should be aware that unless there are very good reasons for it - perhaps to compensate for some other destabilising effect such as high unemployment or high inflation - then we are likely to be moving away from stability.
Unfortunately the natural rate can't be calculated directly, but there are methods available for estimating it from economic data. A much-cited paper on this subject is Laubach and Williams 2003.[191]