Hamish McRae: The Fed, the Bank and the ECB might set rates, but they don't have any power

The US still matters, of course, but the rest of us don't
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The Independent Online

America's interest rates passed Britain's on the way up last week: the official Federal Reserve discount rate was set at 4.75 per cent against the Bank of England's 4.50 per cent. Meanwhile, the European Central Bank is in the early stages of what will probably be several increases, and the Bank of Japan has signalled that it will at last begin to raise rates from the near-zero where they are now.

So the long period of very low short-term rates around the world is clearly long gone. By now, you would expect that these higher rates might have started to slow global demand, but they don't seem to have done so - at least not yet.

Here in Britain, growth has been slowing and, for a while at least, house prices have been tapering off. But that slowdown in consumption seems to have more to do with the rising tax burden than higher rates, or at least that is what the Bank of England seems to think. And now, while retail sales remain subdued, house prices seem to have resumed their upward march.

In the US some signs point to a slight slowing, but most forecasts suggest growth will be in the 3 to 3.5 per cent region this year. So far at least, higher rates do not seem to have changed people's buying habits.

All this raises an intriguing possibility. Maybe interest rates are a less effective way of checking demand than they used to be.

The obvious parallel is with oil. The price of crude oil doubled last year and it remains high in absolute terms. You might imagine the effect of this would have been to clobber global growth. As it turned out, last year seems to have been the best for world growth in more than a decade, and this year looks good too. What's up?

There are several possible explanations and I suspect there is some merit in each of them. One is that the central banks have created so much liquidity over the past five years that the world is awash with cash. You can see that in practical terms in some property markets. In London, the top end of the housing market is shooting ahead again, with many of the buyers paying cash. So the first explanation is that higher rates do not have so much impact on demand because the banks have created a state of affairs where many people don't need to borrow.

Second, even those who do need a loan have big assets to borrow against. In Britain, household net wealth has increased to a point where it stands at more than three times income. Goldman Sachs pointed out in a recent paper that while UK households are living above their income, this is more than compensated for by rising assets. So people are still wealthier than they were a year before.

Third, we are talking about interest rates in the developed world - in the UK, US and continental Europe. But actually most of the additional demand is not coming from here but from the "new" economic giants of Asia. The US still matters, of course, but the rest of us don't.

The chart on the left shows some projections by the Economist Intelligence Unit in a new report, "Foresight 2020". Three countries will dominate growth to 2020, China, the US and India. The largest contribution to global growth from another developed country comes from the UK, and we are down at number eight.

You could argue that what happens to monetary policy in China will be more important that whatever the Federal Reserve does. US demand is very important to Chinese growth at the moment, but the fact remains that China is now the world's largest holder of foreign exchange reserves. This will give the authorities a certain confidence in their dealings with the country's banking system, which is in effect bust from bad lending. At some stage, Chinese banks will have to rein back their lending or at least start to apply Western credit standards. But for the moment, they are being allowed to pump out money to support the country's boom. A rise in rates at the Fed is irrelevant to how China finances a new power station.

If you look at projected changes in jobs, shown in the pie chart, the irrelevance of the developed world is even more evident. The mass of new workers entering the global labour force from China, India and Eastern Europe is already exerting a downward pressure on wages. Expect this to continue. So global inflation, instead of being controlled, or at least heavily influenced, by Western central banks, will be driven by this expansion of the workforce - and driven downwards.

The central point here is that globalisation means Western monetary policy is less important than it used to be and will become less important still in the next 15 years.

What will happen?

Eventually, I think, higher interest rates will check demand in the US. Will they have to go up? Yes, probably. Over the next couple of years, as a result, the US will have a gradual slow-down in growth akin to the one in the UK. But this so-called "soft landing" will not be enough to correct the US current account deficit, for the reasons sketched above, and nor will it do much to slow growth worldwide.

Thus, global growth will continue to be unbalanced, with the world lending the US the money to enable it to carry on consuming more than it produces. At some stage - I would guess in around three years' time - this global cycle will come to an end and that end will in some way be associated with these imbalances. There will then be a difficult period - a global downturn similar to those we have experienced in the past - before growth is resumed.

The analytical problem is that we only know the shape of a cycle once it is over. However hard economic experts try, they are just not good at forecasting global growth in the medium term. We are not even good at knowing where we are now. In the middle of a growth phase in the world economy, such as the one we are in, it is hard to grasp that the growth will come to some sort of end.

When the economic history of this decade is written, it may well be that the monetary expansion of former Fed chief Alan Greenspan will not receive the praise it generally gets now. But the signal for the end of this growth phase may come not from the Fed, the ECB or any of the institutions of the developed world. It may come from a decline in the US housing market but it will just as likely come from somewhere in the world of the newly rich - from China or India.

It's high time Italy fulfilled its potential

It is a miserable backdrop to the Italian elections by any standard. The country has become the worst-performing of the large European economies, with three recessions since 2001 and little overall growth for five long years.

Inevitably this will overshadow the election next weekend. Just as successive left-leaning governments failed to make the necessary reforms to the economy, so too has the rightist one of Silvio Berlusconi. If the electorate had hoped that having a tycoon in charge would revitalise economic performance, they will have been disappointed.

In the short term, there are some hopeful signs. The Italian business community is reporting the highest confidence ratings since 2001, which bodes well for output in the coming months. It may be that the official figures don't take full account of the huge informal economy, estimated to be equivalent to 15 per cent of recorded GDP. Hiring has continued and published unemployment has fallen from more than 11 per cent in 2000 to 7.7 per cent now. As so often in Italy, things are not quite as bad as they seem.

Yet there is still a puzzle. Italy is strong in service industries and at the top end of manufacturing. It offers its people arguably the most-envied life- styles in the world. In short, it is good at doing things that other developed countries cannot do nearly as well. While the statistics suggest otherwise, its economy, viewed intuitively, ought to be competitive.

At least it is pretty clear what the new government, whoever forms it, should do: a series of market-based reforms. These will not solve the underlying problems of demography, for along with the Spaniards, the Italians have the lowest fertility rates in Western Europe. Nor will it solve the overhang of national debt. But the potential is such that a sharp reform programme would bring some quick wins, which would then buy a breathing space to attack longer-term structural weaknesses.

The gap between economic success and failure is such a narrow one, as Britain knows. We should wish Italy well.

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