The faster the US economy returns to normal, the faster US interest rates will return to normal. The positive news about the economy seems to be gathering pace, with decent GDP figures and decent levels of job-creation, so in a way what the Federal Reserve might or might not do has become less important.
Of course it is important in the short-term for a cautious (or incautious) word from the Fed can have a substantial impact on the markets. But as far as the real economy is concerned, the causation is mostly the other way round: it is the economy that determines what happens to interest rates, not interest rates the economy.
It is worth saying all that because there is going to be a wall of sound though the autumn about US monetary policy. Does tapering begin in September? How quickly will the Fed move? What are the implications for short-term rates? And more and more…. It is all going to be very intense, very intricate – and for the rest of us, very confusing. But of course it affects us too. For example, any rise in US bond yields will pull up gilt yields, as indeed has already happened. So what should we look at?
The single aspect of the US economy that I have found the most helpful guide to the future has been the housing market. Put simply, that is where the problem began and accordingly where it is likely to end. Prices now are reasonable, around the middle of the historical band in relation to incomes, maybe a little below. Housing activity has picked up, and so too has sentiment among home-builders (top chart). As a paper from brokers Charles Schwab notes, this improvement in builders' sentiment mirrors a wider improvement among consumers. There is a huge distributional problem, for confidence among the better-off is rising much faster than the less-well-off, but overall there is little doubt that the mood of Americans has lifted.
So too have interest rates. Most of us have been aware of the rise in longer-term rates, with the yield on ten-year treasuries climbing from below 1.5 per cent a year ago to their present level of 2.7 per cent. This climb really began in earnest this April, when they dipped to below 1.7 per cent, as you can see in the bottom graph. What I had not fully appreciated, though, was what was happening to expectations for short-term rates. Barclays has plotted the two together, taking the three-month rate in December next year as indicated by the forward market. Between the beginning of April and the end of May the expected rate then rose from below 0.5 per cent to nearly 1 per cent.
You may say that 1 per cent is still extremely low and of course that is right. But bank funding costs will probably climb faster than the official rate, thanks in part to growth increasing the demand for funds and in part the influence of longer-term rates. That is already happening.
To explain, there are two points here. One is the familiar one that while central banks control very short-term interest rates, they have much less control over longer-term rates.
The other is that while they can hold down official short-term rates, what banks have to pay for deposits – their funding costs – will be dragged up by longer-term rates.
What does all this mean for the rest of us? What happens to US rates affects the rest of the world but so too does what happens to the US economy. According to Consensus Economics, which tracks what more than 250 economic and financial forecasters expect will happen to a range of economic variables around the globe, both the European Central Bank and the Bank of England will delay increasing rates for much longer than the Fed.
That is common sense. But if you ask what should happen to policy, the balance of opinion in Germany has swung towards thinking that monetary policy should become tighter over the next year, whereas in the US there is a decent majority in favour of tighter policy. Here in the UK there is a small balance towards favouring a tighter policy.
As far as we are concerned that reflects the balance of uncertainty about the course of the economy. The evidence is mounting, as some of us expected, that the recovery is both stronger than the run of GDP figures suggested and has in any case gathered strength in recent weeks. (By the way, didn't the IMF make an idiot of itself when its chief economist warned in April that the Chancellor was "playing with fire" by imposing austerity on the UK? That remark looks seriously stupid now.)
As far as eurozone is concerned, the dilemma is that Germany probably does need higher interest rates but the rest of the region needs even easier money. There is no way through this impasse, the reverse of the problem the ECB faced back in 2005 to 2007. We just have to hope that there is a less catastrophic outcome.
The bottom line in all this is that if the US recovery is sustained, as now seems pretty certain, a much tighter monetary policy will follow. I suspect that policy will be tightened somewhat more swiftly than the markets currently expect.
I suspect too that our own economy will grow more quickly than the current consensus expects, though it may take a while for the official figures to catch up with what is really happening.
So on both sides of the Atlantic, normal growth and normal interest rates might be only two years away. About time too.