Hamish McRae: Why it may be prudent for Brown to take a long view on interest rates

We are beginning to see the limits of monetary policy in the United States and we should be aware that we might see them here. What we do not know, however, is whether the Federal Reserve's monetary policies or the Administration's fiscal policies are to blame.

Everyone - and the press are guilty here - tends to focus on short-term rates. It is an easy story because there is the clear headline of "Bank of England cuts interest rates" or whatever. People see a reasonably swift impact on their monthly mortgage costs and the public relations machines of the employers and the trade unions are on tap to welcome the move. When rates turn up, as they duly will, the entire machine will go into reverse.

Changes in long-term rates, by contrast, go almost unnoticed. That is partly because they are set by the market, rather than the central bank, but also because in Britain at least they do not seem to have such a direct impact on our lives. But long-term rates have a big impact on government finances. The sharp decline in rates over the past decade have been one of the reasons why Gordon Brown has been able to appear so prudent and pay back so much public debt. Long-term rates also affect companies' ability to finance themselves by issuing bonds - pretty important when low share prices make equity capital at best expensive. And in the US they affect the personal sector as many home loans are for fixed periods.

There is still some debate as to whether short-term rates have reached the bottom of this cycle. The general view seems to be that there will be a further fall in eurozone rates in the autumn, maybe one in the UK and probably no further fall in the US. There is much less debate about long-term rates, for the general view is that the turning point was reached last month.

This is particularly evident in the US. Since the middle of June the 10-year Treasury bonds have fallen by 10 per cent, the largest six-week drop since 1980. As a result, yields have risen from 3.1 per cent to 4.4 per cent, despite the continued commitment by the Federal Reserve to hold down short rates for the foreseeable future.

Why has this happened? There are at least three possible explanations, each with a bit of truth in it.

One is simply that rates fell too far. Bond markets are just as susceptible to bubbles as equity markets and with the prospect of price stability, maybe deflation, in the air they got rather carried away with themselves.

The second is that markets suddenly became aware of the huge increase in borrowing by the US Federal government over the next two or three years and realised there would be no hurry to buy now while they last. The same argument would naturally apply to the UK and the main eurozone countries too.

And the third is a reconsideration of the wisdom of the Federal Reserve in pushing money market rates so low. At some stage over the next decade money at 1 per cent might carry the tiny danger of creating a little inflation, a danger not factored into a yield of little more than 3 per cent.

At any rate there seems to have been some sort of turning point. The snap-back in US rates both at the 10-year level and the longer 30-year one is particularly vicious, as you can see from the two left-hand graphs. In the UK, we have had a slightly different experience. Yes, rates have come up since mid-June, but the rise has been less marked.

At the 10-year end, we dipped only just below 4 per cent (left hand graph) and generally have had a much flatter performance since the beginning of 2000. At the 30-year level (centre graph), our markets have been flat throughout, so the rise leaves us very much within the two-year trading range.

I would like to think that this suggests that UK markets have a little more confidence in our monetary and fiscal policy than their US counterparts in American policy. Certainly we have had an exemplary monetary policy even before Bank of England got its independence on this matter, as the right-hand graph shows.

There is a formula for calculating what the "right" interest rate ought to be, devised by the Stamford economist John Taylor. It says that real short-term rates (i.e. rates adjusted for inflation) ought to take into account three things. One is the actual rate of inflation relative to the targeted inflation. A second is the level of spare capacity in the economy. And the third is what level of interest rates would be compatible with full employment. I shall spare you the maths, but conveniently the economic team at CSFB have calculated the rate for the UK and compared it with what actually has happened since sterling was ejected from the ERM in 1992 and we were able to re-establish an independent monetary policy.

As you can see we have tracked it very closely, particularly so since 1997. So we have, so to speak, done the right things.

The CSFB conclusion on UK rates, by the way, is that UK rates will be steady at 3.5 per cent through to the end of this year and be back up to 4 per cent by the end of next.

That should be fine. That sort of climb would be consistent with some further rise in long yields but nothing drastic. But there seem to me to be three main worries in the months ahead.

The first is whether the UK's fixed-interest markets could be unsettled by adverse events in the US or indeed the eurozone. Were long rates to rise sharply in the US, which has an even larger budget deficit than we look like having, ours might be pulled up too.

The second is to what extent rising US long rates for Treasury securities will feed through into higher corporate bond yields. I don't mind the US government having to pay more for its money but I would be worried if US companies had to do so. So far this has not happened, for the rise in treasury yields has been offset by a narrowing of the spread between treasuries and corporate bonds. Confidence is returning that most large US companies at least will not go bust.

The third worry is that Gordon Brown has miscalculated by more than we now think. It is clear he will miss his borrowing target but it is not clear what he will do about it. Will he blunder on, borrowing more and saying that "over the cycle" he is still within his so-called golden rules? Or will he cut spending? Or will he put up taxes by even more than he has already?

We don't know, and nor, indeed, does he. But the mood has shifted. I would not lend to this government for 10 years at 4.5 per cent. It does not cover the risks. And I suspect a lot of other people will feel the same.