New research from the Bank of England finds that interest rate cuts in response to the 2007-08 crisis boosted the UK’s birth rate. Yet the same cannot be said of monetary policy’s impact on investment. What does this tell us about the Bank and its toolkit?
Historically, the base interest rate – charged by the Bank of England on commercial bank reserves – has been the primary monetary policy tool (also known as the ‘policy rate’ or ‘bank rate’). In times of economic slowdown, lowering the base interest rate is intended to boost aggregate demand by stimulating household spending and business investment. This is meant to occur through a decrease in current and prospective interest payments on loans and mortgages, assuming that commercial banks pass on the rate cut to their customers.
The Great Recession of 2007-08, however, displayed the full extent to which monetary policy alone is incapable of stabilising the economy. In July 2007, the base interest rate reached 5.75%. It was gradually lowered to 4.5% over the following 8 months, and then drastically slashed down to 0.5% as the full impacts of the crisis set in. Yet the BoE’s rapid rate cut, as well as its subsequent QE programme, proved incapable of jump-starting the economy. Today, the interest rate stands at 0.75%.
To some commentators, this was entirely expected. Post Keynesian economists in particular have long argued that the base interest rate is a blunt instrument that bears little weight on decisions in the real economy. As outlined in a recent paper by Jo Michell and Jan Toporowski, for example, “companies invest in productive capacity because they have customers at their door. The rate of interest merely affects how they finance any investment that they may undertake.” Contrary to conventional economic wisdom, the base interest rate has rarely had much impact on the rate of business investment.
The effect of monetary policy on household spending is also often overstated in economic commentary. However, a Bank of England paper published over the holiday season takes a deep dive into how monetary policy affects the single most important decision households take: whether or not to have children. Prior research had already suggested that monetary policy influences birth rates indirectly through a variety of factors, such as house prices and home ownership, but the BoE’s recent paper investigates a more direct relationship through the mortgage market.
The authors find that every 1% decrease in the base interest rate led to a 2% increase in birth rates. In aggregate, this translated to “14,500 additional babies being born in 2009, and increased birth rates by 7.5 percent over the following three years”. The fertility effect was only seen among families whose mortgages were adjustable and directly linked to the base interest rate (which was approximately a quarter of families of child-bearing age). The authors conclude, therefore, that lower monthly mortgage payments put liquidity-constrained couples in a better position to bear the financial costs that come with having a child.
The paper argues that this is evidence of a new channel by which monetary policy affects the real economy, given that children require additional spending that households would not otherwise undertake: “In addition to food, clothing, and other daily necessities, many consumer durables purchases (such as a larger vehicle) are prompted by the addition of a child. Indeed, estimates indicate that the average cost of raising a child during their first year in the UK is almost £11,000.” The implications for monetary policymakers do not stop there, as changes in birth rates can have significant impacts across the economy and on the transmission of monetary policy.
There is certainly some truth to these reflections, but there is another – probably more important – point to be drawn from this study. The new evidence of interest rate cuts’ effect on birth rates provides another example of an unintended side effect of blunt monetary policy instruments. While rate cuts and QE have largely failed to achieve their goals of boosting spending, investment and lending, we continue to uncover their widespread effects on other aspects of socioeconomic life. For example, over the years, research also revealed that QE had adverse effects on wealth inequality and propped up carbon-intensive economic activity.
While most people would probably agree that increasing the birth rate is a less morally reprehensible addition to the list of monetary policy’s side effects, it is further evidence of the extent to which the Band of England’s policies can affect our lives in ways that are (at least initially) completely invisible to us. Yet the Bank’s decisions continue to happen exclusively behind closed doors with a severe lack of democratic input or public accountability. The interest rate decision, for example, is made by a group of 9 unelected individuals that have barely any professional or demographic diversity (the ‘Monetary Policy Committee’, chaired by the BoE’s governor).
Therefore, while this new finding on the relationship between monetary policy and birth rates provides intriguing technical insights, it also further highlights why the Bank of England is in need of serious reform. At Positive Money, we believe that the public deserves a central bank that is willing to explore new approaches to fulfilling its mandates, with greater democratic legitimacy and accountability.