Hamish McRae: Higher interest rates are on the way, but a double dip is not

Economic Life: There are headwinds to be sure and they will contain the recovery, but they don’t feel sufficiently strong yetto plunge us into a double dip
Click to follow
The Independent Online

The world economy has gathered pace but the headwinds it is meeting are also increasing their force. Here in Britain we have been preoccupied by the tax increases and the forthcoming spending cuts, and with the budget now less than three weeks away, who can blame us for that? But the wider story for the world economy is how well it will counter rising interest rates and higher energy prices. This matters to us here in the UK because we are an unusually open economy: if the world goes on growing solidly we will be pulled along by it, and if not – well, we have a problem.

Interest rates first. Yesterday's comments by Jean-Claude Trichet, head of the European Central Bank, are a game-changer. The wording in the ECB statement following its monthly meeting was stronger than before, suggesting an early rate rise was on the cards. Then, asked about a rise in interest rates at the press conference, Trichet said: "An increase in interest rate in next meeting is possible... it is not certain but it is possible."

The reaction will take a few days to settle down but the general perception is that the most likely time for the first increase in Eurozone rates will be in April and from 1 per cent to 1.25 per cent. Previously the market expected the first rise to come in September. The profile of rates now comes forward. For example, UBS now expects that by September next year Eurozone rates will be 2.75 per cent rather than 2.5 per cent.

So what does that mean for the rest of us? Well, what the ECB does or does not do has little impact on US monetary policy. Thanks to its position as the main reserve currency and thanks to the willingness (so far) of the Chinese to lend the country money, the Federal Reserve has policy freedoms that even the ECB and certainly the Bank of England does not have.

But it will affect us here, for though the Bank would argue that a rise in Eurozone rates has no influence on the monetary committee, in practice a rise in Europe in April would legitimise one here in May. That remains my central expectation.

So the economy and the financial markets have to work on the assumption that rates rise sooner rather than later and that they continue to climb through the next 18 months towards and probably beyond 2 per cent in Europe, here, and I expect also the US.

That is headwind number one. Headwind number two is higher energy prices. The two are linked in that higher energy prices feed through into higher inflation and that forces higher interest rates, but intellectually they are separate – or at least it is helpful to start by thinking of them as such. So what can be said about energy prices that has not already been said?



From a macro-economic perspective a couple of things have struck me in the past few days. One is the resilience of share prices in the face of the really worrying events in the Middle East. It should be said again that this is primarily a human and political story rather than an economic one but there is considerable economic fall-out.

The prospect of a collapse in supplies from one medium-sized oil exporter, Libya, notwithstanding assurances of higher production from Saudi Arabia, was enough to push the oil price up 20 per cent. But equity marketsresponded reasonably calmly. By last night the FTSE 100 and the Dow Jones were back above the levels they were at the beginning of last month. In as far as share markets signal trouble ahead, and I accept they are at best an imperfect lead indicator, the message seems pretty benign to me.

Then I looked at some work by Evolution Securities on the relationship between the oil price and equities, with changes in the oil price and in UK shares shown in the top graph. These are changes, note, rather than levels. Well, three things stand out. One is that the oil price is vastly more volatile than share prices, which is a bit of a relief. The second is that there really isn't that much of a relationship. For they sometimes move together but sometimes seem to go in the opposite direction. And third, in as far as there might be a relationship it is not at all clear which way it works. Do share prices lead the oil price or theother way round?

Put at its lowest, though, it is perfectly possible to have strong oil prices and a strong share performance, for both would be associated with good growth in the economy.

The other thing that has struck me is the solid nature of the recovery if you look from a global, rather than a domestic, perspective. The bottom graph comes from Goldman Sachs and reflects their generally upbeat view on the recovery. As you can see from the bottom graph, there has been a rebound in the global purchasing managers' index, calculated by Goldman, and their projections are for global growth to canter on at between 4 and 6 per cent through to the end of 2012.

One of the issues they do consider is whether oil prices will derail the recovery, noting that there are two transmission mechanisms: the direct impact on real incomes and the indirect one on monetarypolicy. On the first, they acknowledge a rule of thumb whereby a 10 per cent rise in the oil price knocks 0.2 per cent off annual growth for the next two years. This is already fed into their growth expectations. On the second, in the US at least, there does not seem to be much of a link. Europe may feel it should tighten policy if a higher oil and other prices start to push inflation up more generally, but this is not evident in America.

Actually I think the Federal Reserve has been lulled into complacency by the perception of much of the world that the US is a safe haven for spare cash. I am really worried there might be a surge in long-term US interest rates as investors lose faith in the dollar. There are little snippets of stories around about the dollar's days as a reserve currency being numbered but as yet the impact of these fears on US long rates have been reasonably benign. But this must surely be a concern.

There are, however, always uncertainties ahead. That is the nature of the world economy. We have to remember that it is still in the early stages of a cyclical recovery that normally would be expected to last several years. So yes, at this stage, of course, the expectation for interest rates must be up, particularly given they are starting from such a low base. If everyone expects higher rates, you might as well get on with it. As for the oil price, barring some catastrophe, the inflation it inevitably generates should be containable. Yes, more expensive oil trims growth; but one of the reasons why, even ahead of recent events, the oil price was rising was as a result of that growth. So there are headwinds to be sure and they will contain the recovery. But they don't feel sufficiently strong by any means to plunge us into a double dip.

Comments