Rates will rise soon, but what happens next is anyone's guess

We've had near-free money for so long that we have forgotten what the 'old normal' was like

Click to follow
The Independent Online

Six months ago many American economists thought that the first rise in US interest rates would come this week.  There is a tiny chance that it will, but it would be a huge shock if it did. The setback to the US economy in the early part of the year, while mostly weather-related, has pushed the date back three months. The overwhelming probability now is that the move will come in September.

At least that is what the markets expect, and with something as momentous as the first rise in official dollar rates after nearly seven years of ultra-cheap money, you want to prepare the ground carefully. Or at least if you are going to have policy surprises, better for them to be nice ones, not nasty ones.

When rates do go up it will signal the end of an extraordinary period in global monetary policy. I cannot find anyone who predicted, when the Federal Reserve’s open market committee cut the main policy rate to 0.25 per cent on 16 December 2008, that rates would stay low for so long. We all have a natural tendency to assume that what is happening at the moment is more or less normal, but this is not normal at all. Such a long period of near-free money is something that, Japan apart, has never occurred in a major economy in peacetime. The move back to some sort of normality starts this autumn  in the US.

Presumably it will happen soon afterwards here in the UK. Mark Carney, the Governor of the Bank of England, has been at pains to downplay the timing of the first rise, but here as in the US the decision will be data-driven. Had it not been for the collapse of the oil price at the end of last year, which nudged the consumer price index below zero, we would have higher rates now. It looks as if growth last year will be revised up to more than 3 per cent, unemployment is down to 5.5 per cent, pay growth above 2 per cent, and the oil price effect will start to unwind later this year. As Ian McCafferty, a member of the Monetary Policy Committee, said last week: “We are approaching the time when monetary policy will need to begin its journey back to more normal settings.”

That we follow the US up is really only a matter of timing. We moved down to our 0.5 per cent base rate on 5 March 2009, some two and a half months after the Fed, and that sort of delay seems reasonable enough. Should we, or indeed the Americans, fear it? If you see this as a return to normality, surely not. But if you see it as trying to prick an asset bubble – soaring house prices for example – then maybe. It is hard to prick a bubble without a bang.

There is an utterly unscientific rule in economics that the things that everyone is worrying about don’t usually cause big problems, while those that hardly anyone is worrying about come and bite you on the backside. So we should not worry now about the knock-on effects of whatever happens in Greece, but equally we only slowly grasped the scale of the catastrophe that the board of Royal Bank of Scotland allowed to happen in 2007-08.

Apply this to the consequences of rising interest rates, and I suggest that fears of the economy taking a hit are overdone. The housing market will soften, as it needs to, but there is no reason to expect it to crash. As far as corporate borrowers are concerned, if rising rates increase the availability of funds there may be a net positive. As for the impact on consumption, that will probably be neutral, for higher borrowing rates for some will be offset by higher deposit rates for others, particularly pensioners.

So while it is true that property prices have been boosted by easy money policies, and while we have engineered a consumer boom on the back of cheap loans, it should be possible to work our way through this. Property is supported by underlying demand and consumption (at last) by rising real wages. We will have the further advantage of seeing what happens in the US, for these arguments apply there, too.

What should we worry about? That is almost impossible to answer. I suppose one big concern is what might happen if sovereign bond yields – long-term interest rates as opposed to the short-term interest rates set by central banks – move up even faster than expected. At what stage does Japan have to acknowledge that it cannot repay its debts? Are there potential failures in the financial system here and elsewhere that might result from falling bond prices? (The price of course moves inversely to the yield.)

I suppose the biggest concern is whether seven years of industrial quantities of liquidity being pumped into the global system have lulled participants into thinking the money will keep flowing and encouraged them to do stupid things as a result. As Warren Buffett observed: “Only when the tide goes out do you discover who’s been swimming naked.”