Hamish McRae: High interest rates are here to stay - don't expect them to plummet

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The Independent Online

Today the US Federal Reserve will increase its interest rates by 0.25 of a percentage point to 5.25 per cent. If it doesn't, that really would be a big story: the probability is as close to zero as it gets. But this is not the end. The US financial markets have priced in a 90 per cent probability of another 25-basis-point increase in August. The markets then reckon that this will be the peak and there is a lively debate as to the timing of the first cut in rates, perhaps by December. So US interest rates are now significantly higher than UK ones, an unusual condition, and very much higher than eurozone rates.

What is happening and what does this mean for us?

There is a danger of being fazed by an excess of economics. Huge amounts of expensive American intellect go into analysing each twist and turn of the Fed. Every bit of data is dissected. Each statement by the members of the Fed board, and of course of its chairman Ben Bernanke, is picked over for the shaved nuance. Econometric models are devised and discarded. And it is all very confusing.

There is another way of looking at the subject. There is a simple story that runs something like this.

The Fed, under its previous chairman Alan Greenspan, had allowed an asset bubble to get out of hand by not increasing interest rates in time. Having done that it was frightened of making the same mistake as the Japanese authorities, which had allowed an asset bubble to get out of hand a decade earlier, and which did not counter the subsequent slump by cutting rates quite soon enough. By the time it did, it was too late and Japan suffered deflation. So the Fed ran an easy money policy, with rates at just 1 per cent, until it was sure the deflation would not happen. It was encouraged by the lack of inflation in product prices in the US. Eventually it began to "normalise" interest rates but the legacy of cheap money led to another asset boom, this time in property. Just in the past few months that cheap money has started to inflate current prices, which means that the Fed has to increase rates by more than it expected.

That is where we are now. Have a look at the first chart, showing core inflation from 1993 onwards, on a six-month annualised and three-month annualised basis. It shows a pretty satisfactory downward march for a decade until 2003. Since then there seems to have been a clear upward creep. If you look at the three-month line rather than the six-month one, things really appear quite alarming, with inflation reaching 3.8 per cent. That is the trigger for this forthcoming increase in rates.

Against this has to be set the signs that the economy is slowing of its own accord. The signals are mixed, with the housing market clearly coming off the boil but with consumer confidence pretty high (see graphs). Share prices too have fallen sharply. Some observers, such as Capital Economics, which prepared these charts, believe that slower growth rather than higher inflation is the greater danger. The economists at ING would agree, arguing that this rate increase is unnecessary to control inflation in the medium term, but this will not stop a further increase in August.

So the big picture is that the Fed is struggling to balance its objectives and is in danger of overcompensating for its former laxness by pushing rates up too much. My own guess is that there is still quite a lot of vigour among American consumers and that this will take a long time to fall away. Meanwhile, the Fed has to reassure international opinion that it cares about inflation. So these increases in rates are probably justified and they can in any case be swiftly reversed if necessary.

That is them; what about the rest of us?

You have to start from the fact that it has been US and Chinese demand that has sustained global growth in the past three or four years, and the two economies are closely linked. So what we think about US interest rate policy is not as important as what the Chinese think. That leads into a debate about the dollar/yuan rate. Are the Chinese revaluing their currency sufficiently swiftly to head off protectionist pressures? Answer: no. And if that rate does not move much, which other currency might take the brunt of any fall in the dollar? Answer: the euro.

The rise in US rates is undoubtedly protecting the dollar for the moment. Psychologically, a tough Fed is good for the dollar and of course the higher running yield attracts hot money. In the short term, that is good news for Europe. The eurozone does not want to have its nascent recovery aborted by a surge in the euro. But in the medium-term a higher dollar is likely to preserve the current account deficit, now some 7 per cent of GDP. That cannot continue - though I acknowledge that it has continued for far longer than most of us expected. Sooner or later that adjustment has to happen and the dollar will fall. Maybe that will be only a quite modest decline, say 15 per cent, but the longer it takes to come the greater the danger that the decline will get out of hand.

US monetary policy is not set with the rest of the world in mind. The country will get higher interest rates not to support the dollar but to control inflation. There is, however, a general feeling among the world's central banks, reflected in the Bank for International Settlements' annual report at the beginning of this week, that they have allowed themselves to be lulled into complacency about inflation and that they will have to lean harder against it. So the Fed is reflecting a global view, even if it does not pay particular attention to it.

And the problem is not just inflation. It is also credit quality: loans being made at every level to borrowers that don't tick all the creditworthiness boxes. The effect of easy money is that people and companies over-borrow. That is evident in the US but we see this here too in the level of credit-card borrowing and arguably in the size of people's mortgages.

So to set these rising dollar interest rates into their global context is to see them as a continuing correction of a policy error: the error of too cheap money for too long. I have no particular feeling for what the peak in US interest rates will be, or indeed whether the next move here will be up or down. But I think what can be said with some confidence is that we will have quite a long period - maybe another three years? - of quite high interest rates. Rates may or may not go much higher but do not expect them to come down fast. And that goes for UK rates as well as those across the Atlantic.

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