Hamish McRae: Of course rates will come down this week. But they're still high compared with 1667

Click to follow
The Independent Online

So interest rates will come down this week. But how will we react? Will we really rush out and start spending again?

Pause a moment. First, there is the presumption that there will indeed be a cut in rates. Is that safe? Well, one of the curious features of our monetary regime, with the Bank of England publishing its monetary committee minutes and the voting results is that the openness creates a momentum of its own. Thanks to the steady shift among the members towards a cut, the cut becomes more or less inevitable. Looking at it round the other way, not to cut rates next month would be a huge shock. It would suggest that there was new evidence either of renewed inflationary fears or of some hitherto unnoticed bounce in the economy, either of which would come as a big surprise. So, yes, that presumption that rates will be cut does look safe.

That leads to the bigger matter - what then? Now that interest rates are quite low - very low by the standards of the past 30 years - could they be at a level where further cuts are ineffective? If not, why not?

The background here is the shift to a world without any inflation in goods, though with some inflation in services and considerable inflation in many asset prices. The first two graphs above show what has been happening in the US and here.

That is fact but we find it hard to believe. Because many high-profile items are rising sharply in price, from petrol to the London congestion charge, we tend not to appreciate the extent to which "things" are becoming cheaper. Even if we realise they are, we think of this as a blip.

But it may not be. Some of us think that this is probably the start of a period of a generation or more that will be characterised by stable or falling prices globally. The reason? It's too early to understand fully, but it has something to do with the power of the bond markets and maybe more to do with the economic rise of China.

The bond markets crushed the excessive inflation of the 1970s but drove up long-term rates to such an extent that governments were forced to bring in all sorts of measures to control the cost of their borrowing. These included monetary targets, inflation targets and more independent central banks. But that process was largely over by the late 1990s. The downward march in the price of manufactured goods has been driven by China. You can see the relationship in the right-hand graph.

The economics team at ABN Amro, which drew attention to this relationship, does warn that the loosening of the yuan's peg against the dollar is the start of a more general revaluation of Asian currencies. That, it believes, may lead to higher inflation in Europe and the US as the price of Chinese and other East Asian imports rises. At the margin that is probably right. Nevertheless, a huge mass of spare low-wage labour in China, and indeed in India, is hitting the world market in traded goods and services. This will have the result of holding down the cost of labour globally for at least a generation.

The effect on developed countries' labour markets is starting to become apparent, in particular with a hollowing out of middle-income jobs (see below). The effect on developed country financial markets is less easy to identify because of the background noise from other forces, but I think will increasingly show through too.

Alongside the surge in the supply of labour hitting the global economy from East Asia is the surge of savings. Those savings help to hold down long-term interest rates - bond yields - as these savers put their money into developed country assets, mainly in the US but also in Europe and the UK.

Oversimplifying, Asia is holding down global wages, global prices of traded goods and global interest rates. There will be economic cycles, of course, but Asia will go on doing that for the foreseeable future.

Some new work from Merrill Lynch provides an interesting cross-check on this proposition. It has produced a paper called The History of Inflation and Innovations, which looks at US inflation since 1667 (gulp) and concludes that between then and 1950, inflation was stable or negative for more than half the time. It says that "it looks as though we are reverting to the long-run norm of price stability".

It also notes that for a quarter of the time since 1831 yields were below present levels - ie while levels now are very low, they are not uniquely low for a world of price stability.

So you can see how the professionals in the markets are reacting. What about the rest of us?

Here we are heading into an unknown land. Common sense says that we should not be seduced by low interest rates into thinking it is a good idea to over-borrow. That holds for borrowing for consumption: silly to borrow to buy something now when it will be cheaper in six months' time. And it could hold for buying assets too. Anyone in Japan who borrowed to buy property 15 years ago will be sitting on an asset worth perhaps half what he or she paid for it: whatever the interest rate, it will have been a bad deal. Unsurprisingly, even though interest rates have been close to zero in Japan, at least at a wholesale level, near-free money has not stimulated borrowing.

If in this world of stable prices, while people should rationally only borrow for essentials, few of us are prepared to adopt such a hardline approach. But as the message that prices will be stable sinks in, expect reason gradually to triumph.

Hence a fall in interest rates this autumn will be something of a test case. House prices are at the moment falling. Will a few modest cuts in rates - to, say, 4 per cent - encourage a sufficient increase in demand for prices to recover? Or would it need much lower rates - say 2.5 per cent - to get prices moving again?

How will we react to credit card debt, which carries absurdly high rates of interest? Could we be in the early stages of a retreat from such debt, the first retreat since plastic took over our lives a generation ago? (To be clear - we will still use the cards for payment, just not borrow so much on them.)

My guess is that this is all a bit early. I suspect that modest cuts in rates will have less effect on the economy than most people believe, but I don't think that society has changed enough to start a more general retreat from indebtedness. The idea that it is stupid to pay double-digit interest rates will gradually take hold but that will take a generation - just as it did for people to realise that they should mortgage themselves to the limit to buy the best home they could manage.

Let's wait for next month and see what a quarter point off base rates does. I don't think we will be dancing in the streets.

Comments