Hamish McRae: As this strange period of near-zero rates draws to a close, the question is: what next?
Sunday 06 March 2011
I don't think it is going to happen but we can't rule out the possibility that UK interest rates will go up this week.
It is more likely that the first rise, by 0.25 per cent to 0.75 per cent, will be in May. But what is beyond dispute is that 2011 will be the year when interest rates around the world start to climb back towards more normal levels. So we had better start thinking about the consequences of that.
The game-changer was the clear signal from Jean-Claude Trichet, the president of the European Central Bank, that it may increase rates next month. Of course the Bank of England does not have to follow the line of the ECB – we have an independent monetary policy – and Britain's circumstances and needs are different from those of the eurozone. But global interest rates, at least within the developed world, tend to move loosely in synch, with Europe and the UK somewhat closer than the link with the US. (The fact that the dollar remains the principal reserve currency and that the US is a less open economy than the major European ones gives the US a policy freedom other countries do not have.) So when Europe moves I don't expect us to be far behind.
Why is it now odds-on for Europe? Central banks do not set rates in a vacuum. They only have control over short-term rates as the longer the term of the deposit or security, the greater the influence of the markets. Thus 30-year government bond rates are entirely set by markets and 10-year ones mostly so. If a central bank is seen to be too soft on inflation, long-term rates will rise. And so in setting the short-term rates, central banks have to work within the inflation outlook for the economy.
There is a theoretically "correct" interest rate, called the Taylor rule, as it was developed by Professor John Taylor of Stanford University. Put simply, the central bank should take into account the actual inflation compared with the target rate of inflation, and the actual output of the economy compared with its full capacity output. If actual inflation is above target rate, interest rates should go up. And if actual output is below potential output they should go down. It is a wee bit more complicated than that but you see the principle. Now look at the main graph, taken from some work by Commerzbank.
The red line is the official ECB interest rate. The blue line is the Taylor rule rate, what – given inflation and output – the ECB rate "should" have been. As you can see, the two tracked pretty closely until the collapse of 2008 and the dreadful 2009, but then the Taylor-rule rate actually fell well below zero before climbing last year. I suppose you could say that the ECB pumped money into the banking system with its version of quantitative easing, so, in a sense, while its interest rate of 1 per cent was too high, it took other measures to fit in with the spirit of the rule. But now, as the European economy is scrambling back to normal, you can argue that rates are clearly too low. Of course the Taylor rule should only be used as a guide, and the periphery of the eurozone is still in intensive care and can use artificially low interest rates. But eventually, monetary policy, like fiscal policy, has to come back to normal and you can make the case that if everyone sees you have to do something you had better get on with it.
And so it will be with UK interest rates. The British economy feels a little weaker than the core European one and we have a worse fiscal situation than France or Germany, but we also have a worse inflation problem. There are practical arguments for waiting until after the Budget, but let's see what the monetary committee does this week. In headline terms, it would cause a bit of a stir were rates to go up now, but in the broad scheme of things, a month or two either way will not seem that important in a couple of years' time. The main thing to get our heads around is that this strange period of near-zero interest rates is coming towards its end.
You then start to think about what this might mean. Most obviously, might higher rates abort the global recovery? Will they hit the housing markets? What will they do to share prices? What does this do to tensions within the eurozone? If America is tardy in increasing rates when everyone else does so, will there be a run on the dollar?
It is such a huge and uncertain subject that it is impossible to do more at this stage than set out some initial thoughts. I suppose my main thought is that we should be no more worried about rates going up too quickly than we should be worried about them going up too slowly. In 18 months' time rates here and in Europe are likely to be between 2 and 3 per cent. By any historical standards that will still be very low, maybe even below the rate of inflation. If there were any evidence that higher rates were damaging the recovery the rises would stop. In any case I think we know that availability of finance and willingness to borrow are more important than the notional rate of interest set by the central bank. (I am much more worried by the danger that clumsy re-regulation of the banks will artificially restrict the supply of finance than the price of the stuff.)
Housing markets? It's hard to generalise because not only are national markets very different but so too are regional ones – witness the boom in upper-middle and top-end homes in London and slack conditions in the Midlands and North. As far as the UK is concerned some modest rise in rates coupled with better access might support prices better than the present combination of cheap money but few loans.
Shares? The graph on the right, also from Commerzbank, is interesting in that it supports the notion that shares do best (in the sense that they sustain the highest price/earnings ratios) under conditions of low inflationary expectations. So rises in rates, insofar as they are seen to be containing inflation, need not hit equity values. Only if inflationary expectations were to rise several points would that reduce share values.
And the rest? Look, the big point is that we have to get back to normal. It is a dangerous time because the central banks may make mistakes. But it is not as dangerous as it was two years ago, that's for sure, and we can take some comfort in that.
Poor Portugal has a pig of a time as fellow states seek to rejig their own bail-outs
Greece, Ireland – and Portugal? The next few days are important in determining whether Portugal goes for the bail-out from the European Financial Stability Facility that the markets now expect it to need. It will be trying to sell some two-year bonds and will probably manage to do so at an acceptable rate. But it will need longer-term money shortly and the market rate on its 10-year debt is above 7.5 per cent, a rate which the country could not sustain. Better to get the funds at, say, 6 per cent, from Europe instead. The markets accordingly see a bail-out as only a matter of time. On Friday the rating agency Standard & Poor's downgraded the credit ratings of four Portuguese government-backed agencies, claiming that the state may be unable to support them.
The scene is complicated by the fact that the next meeting of eurozone finance ministers is this Friday. Assuming the next Irish government is in place, the country will have a new finance minister there, elected on the platform of trying to renegotiate the Irish deal, seen by some as overly harsh. This is not the ideal timing, for obvious reasons. But it gets worse, for Greece wants to renegotiate its terms too, and there are worries that Spain may not be able to meet its financing needs this summer. Spain is a far larger economy than Greece, Ireland and Portugal put together.
This is a profoundly difficult background in which to plan for the longer term. In theory the EU has to replace the EFSF, always a temporary patch, with something permanent by the end of this month. The summit set for 24-25 March is supposed to settle all this. But it is extraordinarily hard to come up with a comprehensive package, agreed by all and most especially by Germany, in this crisis atmosphere. The key issue is to what extent and on what terms do the strong eurozone countries give a de facto guarantee on the debts of the weak ones. And poor Portugal is caught in the middle.
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