Hamish McRae: If you lend to the UK you are expecting a zero return. Seems mad?

Economic View: The valuations of the dotcom boom now look absurd. I suggest that applies to today’s bond market

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The Independent Online

There are two ways of looking at UK monetary policy at the moment. You can see it through the lens of the British economy, the pace of recovery, the politics of the timing of the first rise in interest rates and so on. Or you can put what we are doing here into a global context of ultra-easy money and unsustainably low interest rates. Both matter, but the second matters more.

What we have here is a classic dilemma, which was highlighted in the Bank of England’s Monetary Policy Committee minutes. In the short term there is no need to tighten policy and there are plenty of good external reasons, including the weakness of the eurozone, for not doing so. There would also be a presentational problem in raising interest rates when the consumer price index is so far below target. In the long term there are lots of reasons to tighten policy, including the growing evidence of incipient inflation, and the fact that the headline figure is artificially depressed by the plunge in energy prices.

What you do is a judgement and, for what it is worth, I expect in another two or three years’ time the view of the two “hawks” on the MPC, who are calling for a rise in rates, will be proved right. Ian McCafferty was previously chief economic adviser to the CBI and has had more direct connections with the business community than the other members, while Martin Weale, formerly director of the National Institute of Economic and Social Research, has an extraordinary intuitive feeling for what is happening to the economy. The MPC is well-staffed at the moment. There have in the past been weak members, but there aren’t now. So the view of the majority should be respected, but I think it is wrong.

One reason is that there has been an institutional bias in favour of inflation. During the boom years, the MPC was misled by apparently benign inflation numbers and failed to lean against the boom. We can now see that prices were unsustainably depressed by the emergence of China into global trade, which depressed goods prices worldwide. When the incipient inflation did feed through into the system it was too late. We tend to forget just how bad our inflation performance has been over the past few years (see top graph), and actually how that poor record has depressed real wages.

The other reason is demonstrated in the bottom graph. The purchasing manager indices may be a crude measure of business confidence, but they give a decent feeling for future growth. As you can see there has been some slight shading back of the optimism of the spring, but it remains above 55, higher than it was during most of the boom years. This is a commercial sector that could easily withstand a modest rise in interest rates, indeed one that might benefit from it, since business as a whole is cash-rich.

All this we know. What is surely even more interesting, though, is how UK monetary policy fits into the global picture. Within the developed world we have a two-tier outlook, with the Anglosphere facing tighter money and Europe and Japan expecting yet more easing. It may even be that the US will lead the UK into the first rise in rates some time next year. Once it moves that would, so to speak, blow the cover for any further delay in the UK. One reason why is the evident damage that free money is doing to global financial patterns. I have looked at some work by Consensus Economics on expectations for inflation over the next 10 years and corresponding 10-year government bond yields.

To start with the UK: here the consensus view of economists is that inflation will average 2.2 per cent over the next decade. So what is the current 10-year gilt yield? It is 2.2 per cent. So if you lend to the Government you are expecting a zero return. If that seems mad, the situation for other major economies is madder. For Germany inflation is expected to be 1.8 per cent, yet Bunds yield 0.8 per cent. So you lose 1 per cent a year. For France the numbers are 1.5 per cent and 1.2 per cent, so you lose 0.3 per cent a year. In Japan you would expect to lose money, and the numbers are 1.6 per cent and 0.5 per cent, meaning you would lose 1.1 per cent a year. And so on. In the US you would squeak a small profit, for inflation is expected to be 2.1 per cent and 10-year Treasuries yield 2.4 per cent.

So what are these rates saying? There are several possible interpretations. One is that investors are being and will continue to be forced to buy government debt on which they will lose money and that this is the way governments will avoid a formal default. It is called “financial repression”. That probably applies to Japan. There is a version of that which could be applied to the UK, with our pensioners pushed into government bonds on so-called prudential grounds. Another explanation could be that Germany will leave the euro and revalue, and the revaluation will compensate for the negative real interest rate.

Or another more general explanation could be that this is a bond bubble. Yields are far too low; hence the capital values are far too high. At any particular point in markets you always have a balance of buyers and sellers, but with hindsight there have been periods where buyers have been deluded. The valuations of the dotcom boom now look absurd. What possessed these clever people to be so stupid? I suggest that applies to bond markets now.

Central bankers know all this. They know somehow they have to nudge up bond yields just as they have to nudge up short-term rates. But it takes judgement and courage. If it is indeed the Fed that makes the first move up, then that is where that courage will reside.

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