America sets the economic tune and Britain will eventually dance to it

It is clear that the Fed will be competently and wisely led by Janet Yellen. We should be thankful

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The Independent Online

So the first increase in US interest rates will come in June. Well, maybe a bit later, but almost certainly by the autumn. That at least would seem to be the message that Janet Yellen, chair of the Federal Reserve Board, has been seeking to get across in recent weeks.

Today, at the start of her two-day testimony to Congress, first to the Senate and then to the House, she was quite consistent with that. She was very even handed. There is no predetermined date, for that will be shaped by what happens to job-creation, inflation and asset prices, but we should be prepared for a gradual tightening of policy. As she spoke, the dollar rose and yields on US Treasury securities climbed a bit, though she warned that an increase in the Fed’s benchmark rates was unlikely for “at least the next couple” of Fed monthly meetings.

Sometimes, just sometimes, central banks want to surprise the markets, but this is not one. Typically they use shock tactics when they want to jump-start the economy – or in the case of the European Central Bank, rescue the currency, as we saw with Mario Draghi’s “whatever it takes” remark in July 2012. By contrast when they want to slow a recovery, but crucially not undermine it, they prepare the ground beforehand. The aim is to make sure that when the tightening does come it is seen as something normal and natural, and therefore easily accommodated by borrowers and lenders alike.

This matters, not least because it affects the rest of us. One of the things that becomes very evident at  a time of big shifts in economic policy and performance is just how important the US still is to the world. Take energy policy: the fact that America engineered the shale oil boom has not only transformed the global energy outlook and given a boost to the world economy, it has also shafted Russia. Now it looks very much as though Britain will follow the US with rising rates.  It is true that the ECB is not going to follow the Fed in tightening policy any time soon. As and when it gets its own version of QE off the ground, it will be belatedly following the Fed’s loosening of five years ago. But there you could say that it was the Fed that provided the intellectual leadership and that the ECB has simply been a slow adopter.  

So rates go up, led by America. But how fast? The conventional view, supported by everything Fed officials say, is that rates will remain relatively low.  just about as far as anyone can see. 

If you look at market interest rates, that is what the markets are saying. Thus 10-year US Treasury securities were today yielding 2.07 per cent, up a little but not much. UK gilts were even lower, at 1.8 per cent. The equivalent German yields were right down at 0.37 per cent, a reflection of the fear of a decade of deflation in the eurozone.

But this is just a snapshot of views at the moment. A year ago US 10-year rates were a full percentage point higher. Three weeks ago, they were nearly half a percentage point lower.

So the question is whether this prospect of a gradual increase in rates will turn out to be right. There is one reason why rates may go up faster, which is that the global glut of savings may be drawing to an end.

Every year for the past 60 years, the Annual Equity Gilt Study gives a long perspective on what has happened to returns on shares, fixed-interest securities and cash, since 1899 for the UK and 1925 for the US.

The big message is that over a long period shares give a higher return in real terms than fixed-interest investments: 5 per cent versus 1.3 per cent over 115 years in the UK; 6.7 per cent vs 2.6 per cent over 89 years in the US. But over shorter periods, including the past year, fixed-interest may do better. The relevant point for long-term interest rates is that they have been artificially depressed not just by official policy but by demography. Young people save; pensioners run down their savings. So as the world ages, savings are likely to go down. It would follow that rates will tend to rise in the future.

This is an issue that goes beyond the short-term outlook for rates, so skilfully handled by Janet Yellen today. From everything she has done in her first year of office, it is clear that the Fed will be competently and wisely led. We should all be jolly thankful for that. But we should remember that even the most powerful central banker is not all-powerful. Yes, interest rates will probably remain low for some time. But on a 100-one-hundred year view they are exceptionally low now, and demography suggests they will trend higher.

The young suffer, but not as much as those in Italy and Spain

Are we unfair on young people? The commitment, restated by the Prime Minister, that pensions and pensioner benefits will be protected were there to be a Conservative-led government, has reawakened the whole issue of inter-generational equity.

That incomes of pensioners have been protected under the Coalition, whereas just about everyone else – and particularly 20-30 year-olds – have been squeezed, has given edge to the debate. Both the Lib Dems and Labour refuse to support the commitment, even though the old have higher turn-out rates at the polls than the young.

This is not, however, a new issue. The baby-boomers may be an unusually lucky generation, for unlike their parents they grew up in peacetime, hit the job market at a time of full employment, in most cases bought their houses at favourable prices, and mostly have decent pensions. It is true too that young people starting their careers will have less of a following wind, partly because they will have to save for their own pensions as well as paying those of their parents, and partly because of the cost of buying a home.

They also rack up student debt, whereas the lucky ones a generation ago were paid to study in those distant days of university grants.

But there is another inequity, which in Britain at least is less evident than in much of Europe, which is that at least there are jobs. Young Italians and Spaniards have to come to Britain or Germany to find work, and are often over-qualified for what they are doing.

Whether you hit the job market in a boom or a slump affects people’s careers and that is monstrously unfair. There are other advantages, for while real incomes at starter jobs have stagnated for the past decade, they are higher than they were 20 or more years ago. The greater freedoms of society must be worth something too.

So maybe it is less a question of the young being unusually disadvantaged but the present retirees being unusually advantaged. Just don’t try to take away their bus-passes….

h.mcrae@independent.co.uk

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