Hamish McRae: Higher US rates, like higher oil prices, will cause only a blip to world economy

The lesson from Japan is that excessive asset prices can hang over an economy for a long time
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The Independent Online

So US interest rates are higher than British ones. Strange - this does not often occur. This inversion may get greater if the next move in the UK is down and in the US is up. So what is monetary policy trying to tell us and what will be the consequences? Will, for example, the rise in US home prices slide to a halt and will America be able to engineer a "soft landing" from its growth spurt, as the UK seems to have managed to do? Or has the rise in US rates come too late?

Stand back a moment and look at the global picture. We are now at the end of a long period of very low interest rates, rates that were actually negative in real terms in many countries, as the central banks of the US, Japan and the eurozone tried to boost demand by cutting the price of credit. Even the UK experienced the longest period of such low short-term rates for half a century, at least in nominal terms.

This is an unknown land. Previous experience of using cheap money to crank up economic growth led to a surge in inflation. The UK had an extreme version of that in the 1970s and a relatively minor one at the end of the 1980s. But this time it has not happened. Even a doubling of the price of oil led to only a modest blip. Why?

The conventional answer is that the inclusion of China and India in the global economy has depressed prices of manufactured goods and of tradable services. There must be something in this. The influence of these two countries goes far beyond their direct exports, for the possibility of off-shoring jobs helps hold down the price of labour in the West. Note that it is the public sector, not the private sector, that has gone on strike in France and Britain this week. Clearly the public sector feels it is protected against foreign competition in a way that the private sector does not.

However, though the price of goods and labour has not risen much, the flood of cheap money has led to a rise in asset prices. Shares have recovered and are quite expensive by historical standards, though not ridiculously so. And we all know about house prices. So, the conventional wisdom runs, the flood of money created by the central banks had to go somewhere and it did not create current inflation, it created asset inflation. As a result, the Bank of England, and subsequently the Fed, felt they had to respond even though the conventional inflation indicators were not showing any cause for concern.

For Japan and the eurozone, the picture is somewhat different but disturbingly each carries a message for the US and maybe the UK. Japan has battled with deflation since the early 1990s and is only just recovering. In the past month, the Bank of Japan has signalled it will at last start to increase interest rates from the near-zero they have been for a decade. The core of Japan's problem has been that the scale of their asset price boom of the late 1980s was so great, and the subsequent collapse so extensive, that even free money could not revive the economy.

In the eurozone, the problems have been different. There are a vast variety of different underlying economic conditions. The stagnation in Germany has been widely reported. What would by UK standards be a very modest uplift in demand is being regarded as a great economic triumph. By contrast there has been a property boom in Spain of unsustainable proportions, with the country building 700,000 homes a year. There are just some signs of a bust there. I was in the south of Spain this week and picked up rumours that property prices were now falling, though I was told no one would admit it yet.

These different experiences give some hints about the dangers ahead.

As far as Japan is concerned, mercifully the US and UK booms have been on a much smaller scale than the Japanese. We also face less of a headwind from adverse demography. The lesson, though, is surely that excessive asset prices can hang over an economy for a long time, 15 years in the case of Japan. So though the US and UK may escape the threatened house price crash, we could both be in for a long period of stable property prices, perhaps a decade.

As for Europe, the issue there is the cost of getting interest rates wrong. It is no fault of the European Central Bank that it has done so. Because it has to set a single rate, it is inevitable that some parts of the eurozone, such as Germany, will have too high a rate, while others, such as Spain and Ireland, will have too low a one. Eurozone inflation rates, far from coming together since the introduction of the single currency, have actually diverged.

Now come back to the situation in the US. Most professional Fed-watchers seem to think there will be at least one more rise in rates, to 5 per cent. The question is whether that will be enough to cap the US boom. There are some signs that the rate of increase in property prices is slowing; maybe consumption is slowing too. But these higher rates will continue to support the dollar and the imbalance between the US and the rest of the world is enormous. The latest UK current account figures show a deficit of 2.7 per cent of GDP last year; we don't have full data yet but the corresponding US figure will be more than 6 per cent. That is a huge overhang. It will eventually adjust but it will take a decade to do so.

What we need to know is whether US rates at 5 per cent are high enough to start that process. In other words, are we close to a turning point, not just in interest rates but in global financial conditions?

My instinct is we are not there yet. The rise in UK rates, stopped last summer, managed to check the housing boom, but that seems now to have resumed. Asset inflation psychology remains. This is a worldwide phenomenon. The world's newly rich, wherever they are - Russia, the Middle East, China, India or Manhattan - have to put their money somewhere. They have to buy something and for a while yet that will put a floor under asset prices.

The rise in rates affects those of us who have to borrow. But the new rich, the creation in part of five years of easy money but also of globalisation, to paraphrase Scott Fitzgerald, are not like us. They don't have to borrow.

That is the legacy that Ben Bernanke has inherited at the Fed. More than any other central bank, the Fed created this flood of global liquidity. It has had willing collaborators in the US public with their thirst for consumption, the US administration with its rising fiscal deficit, and in the Chinese authorities in their willingness to hold their currency down by piling up reserves.

Eventually higher interest rates will start correcting global imbalances. But I think not yet. For the time being the world economy will shrug off higher US interest rates, just as it has higher oil prices. That suggests that US rates will remain high for quite some time.