Good news or bad news? The Bank of England did not increase interest rates last week, but that was not so much because its previous increases had done the job of curbing inflationary forces; it was because the ructions in the world's financial markets were making credit more expensive without the Bank needing to act. The markets were, so to speak, doing the Bank's work for it.
The central point here is that no country – or, in the case of the eurozone, no monetary authority – sets its interest rates in isolation. Conditions vary from place to place, and different regions need different rates at different times. But money is now a global commodity, flowing across national boundaries at the click of a mouse. And while the various central banks are able to control the price of very short-term money, they have much less influence over longer-dated stuff. So if the world price for money is heading upwards, as it seems to be doing, it is likely that everyone will be swept along.
You can catch a glimpse of this by looking at what has been happening in the London money markets in the past few days. Last Wednesday, for example, the overnight interest rate was 5.9 per cent – a little bit above the Bank's 5.75 per cent base rate but not particularly so. But the three-month rate, the one at which a bank would have to borrow for a three month deposit, was 6.87 per cent. The British Bankers' Association notes that this is the biggest gap between the overnight and three-month rates since the collapse of the New York fund Long Term Credit Management in 1998.
That gap will come down as the markets settle down. But it is likely to remain higher than it has been in recent months. The practical point here is that the three-month rate matters to banks a lot more than the overnight one, and as a result, the trend will be that they have to charge more for their loans. I would expect terms on mortgages to continue to tighten during the coming months irrespective of whether the Bank raises the base rate further or not.
Will there be any global easing of credit conditions that might make life easier for borrowers? Probably not. The real three-month interest rate (the one allowing for inflation) in the main developed countries is still not particularly high by historical standards. Money is no longer ridiculously cheap but it is not very expensive. Given the global demand for commodities and the consequences for inflation – oil now at a new record – it seems likely we will have a period when real interest rates remain above their long-term average. UK rates may not go much higher (though I still would not rule out a move to 6 per cent eventually) but do not expect them to come down much either for the next couple of years.
Might American rates drop and might that change things? House prices in the US are now clearly falling and it is possible there will be a recession there. That would certainly provoke the Federal Reserve to cut. Consumption growth has also slowed dramatically.
But we should not assume that what America does has quite the influence on the world it used to. Yes, this scare began with the collapse in the price of US "sub-prime" mortgages, so the UK and continental Europe are affected by US financial markets. But you have to make a distinction between markets and the real economy. Demand in Britain and on the Continent seems unaffected, at least so far, and the rest of the world appears almost immune. I have spent much of the past two weeks in China and the economy there seems set for growth of close to 12 per cent this year.
Goldman Sachs, which pioneered the notion of the rise of the Bric economies (Brazil, Russia, India and China), has done some new calculations about the US and the Brics. Goldman's economics team thinks that the additional consumer demand from the Brics in the first half of this year was greater than the additional demand from the US consumer. If that is right, and I see no reason why it shouldn't be, this is a big switch.
It means, for a start, that the world is less dependent on the US consumer to sustain demand. It will help American exporters to start to correct the huge trade imbalance, for there should be good demand for their output. But it also means the global appetite for commodities and energy will continue to increase. That, in turn, means global inflationary pressures, and demand for investment, are likely to remain strong.
This will affect the shape of this economic cycle. Were it not for the Brics, you would expect a slowdown in the US to lead to a slowdown in the rest of the world. America is, after all, 30 per cent of the world economy.
But now it seems reasonable to expect demand from these other economies to sustain this cycle for longer than would otherwise be the case. Of course nothing is for ever and we don't know how long the Brics will sustain this pace. But the Goldman Sachs team makes a good point when it notes that were China to slow, it would be much more cautious about world demand. One might, the team observe, almost say "thank God for China".
People will have a variety of views on that, but if you are simply interested in sustaining global demand, there is no question about the importance of the newly industrialising world and that is something we will have to get used to.
As far as the UK economy is concerned, we have to assume that global demand will remain strong. That will help the economy but it also means commodity and energy prices will remain strong. So the scope for cutting interest rates in the coming months will be limited, if it exists at all.Reuse content