Who could have imagined it? Who indeed? The policy of ultra-low rates, bolstered by Quantitative Easing (QE), seems both perverse and unjust to many people (including the Prime Minister). But in pursuing this approach the Bank of England has merely followed the modern orthodoxy. The two major questions now are whether in today’s conditions the orthodoxy is correct; and, even if it is, have conditions so changed as to warrant a different policy setting?
Apart from their possible effect on the currency (about which more below), lower interest rates tend to boost aggregate demand through three main channels.
First, they alter the relative appeal of present versus future spending. They make it more attractive to borrow for consumption now, and less attractive to save for future consumption, thereby switching spending from the future to the present. Also, at any given rate of expected return, lower rates make investment more profitable.
Second, lower rates tend to boost the price of a wide range of assets, including bonds, shares and property, which increases the total stock of wealth. This could persuade people to increase their spending. Third, lower rates transfer income from savers to borrowers. If borrowers have a higher “marginal propensity to spend” than savers (which is conventionally assumed) then lower rates should increase overall consumer spending.