Stephen King: It's wrong to think rates will keep on rising

The biggest problem is the sustainability of the current recovery and its dependency on leverage
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The Independent Online

In a few days' time - 30 June, to be precise - the world economy will reach an important turning point. US interest rates will be heading upwards as the Federal Open Markets Committee (FOMC) concludes its forthcoming two-day meeting on monetary policy. This will be the first increase in American interest rates since 16 May 2000 and the first increase from a cyclical trough in American interest rates since 4 February 1994.

Why raise rates? The evidence supporting the need for monetary action has slowly accumulated through the first half of 2004. US economic growth was better than expected in 2003. Jobs growth finally came through in the first half of 2004. The risk of deflation now appears to have sizeably diminished as price pressures have mounted (see left-hand chart). The global economy appears to be on a better footing. And external pressures on the formation of inflationary expectations - higher oil prices, for example - suggest that nominal interest rates may now simply be too low.

Financial markets tend to see the world in very much black and white terms. Either we're living in a world in which interest rates are permanently rising. Or we're living in a world in which interest rates are permanently falling. There is no half-way house. So, if interest rates are heading up, they're heading up forever.

Which is another way of saying that financial markets are not great at seeing around corners. Interest rate increases in any one year are often followed by interest rate reductions in the following year. Take 1994 as an example. All bond investors remember 1994 because it was the year in which they got their fingers badly burnt. Bond yields rose dramatically as inflationary fears gathered pace and as short-term interest rates swiftly went up. After the first increase in official interest rates - from 3 per cent to 3.25 per cent - at the beginning of February 1994, Fed funds rose to end the year at 5.5 per cent, before moving even higher to 6 per cent on the first anniversary of the initial monetary tightening (see right-hand chart).

But then look what happened. In mid-1995, rates began to fall again. Of course, they never looked like they were heading back down to the earlier troughs but, nevertheless, the fear of further monetary tightening came to an end very quickly indeed. In both July and December 1995 and then again in January 1996, the Federal Reserve cut interest rates, on each occasion by 0.25 per cent. It wasn't then until 1997 that rates went up again. All the while, American inflation performance was a lot better than feared, allowing the Fed a lot more flexibility on monetary policy than the markets had originally assumed.

So where are we heading this time? I argued last week, in the context of the UK economy, that central banks might have to wave goodbye to the language of gradualism and at least threaten more aggressive interest rate action, if only to reduce the consumer's voracious appetite for credit-fuelled spending, helped along by persistent gains in real estate prices. This argument also, I think, applies to the US. So far, the Federal Reserve has argued that it will raise interest rates in a "measured" way, which arguably doesn't say an awful lot but which markets have interpreted to mean in a "cautious" or "slow" fashion.

This may have to change should the consumer carry on spending aggressively. However, it is worth noting that the challenge facing the Fed may be a little less than the Bank of England's. The approaching headwinds for the US economy are, in the short-term, a bit more bracing than those confronting the UK. First, house price inflation isn't racing away in quite the same way in the US as in the UK (although it's still been very strong by US standards.) Second, a lot of US homeowners fund their mortgages on the back of long-term interest rates which have already risen a long way - more than 1.5 per cent - and which, therefore, should be seen as a greater tightening of credit conditions than seen so far in the UK.

Third, the Federal Reserve is well aware that the Bush tax cuts, which played such an instrumental role in maintaining consumer spending, are running out in the middle of this year. So, although employment growth has picked up, post-tax incomes will no longer be receiving a subsidy from the government. And, because of that, there's a reasonable chance that consumer spending will gradually fade later on.

The biggest problem, though, is the sustainability of the current recovery and, in particular, its dependency on leverage. For both the US and the UK, growth has been better than elsewhere in recent years in part because of aggressive shifts in macroeconomic policy. One easy way, for example, to distinguish between the rate of expansion in the US and the UK relative to that in the eurozone is simply to take into account the ways in which the policy levers were manipulated. Lots of rate cuts and lots of fiscal expansion in the US and the UK, virtually nothing in the eurozone as a whole.

This approach has clearly worked well in the short-term, but it has also encouraged a leverage culture, which may now be quite difficult for central banks to manage. Unusually low interest rates appear to have triggered a series of asset price bubbles, the most obvious of which lie within real estate. And here there is a potential inconsistency. Homeowners have, perhaps, been persuaded that they've never had it so good: their confidence in future income growth is high but, at the same time, they've been able to borrow at remarkably low interest rates. This combination is simply impossible to maintain over the medium term: strong income growth should mean relatively high real interest rates or, alternatively, low real interest rates should imply relatively low income growth.

This "having your cake and eating it" approach to policy may have encouraged excessive asset accumulation and an excessive build-up of debt. One sign of this - at least in the US - is the lack of external adjustment. The continued expansion of the US current account deficit suggests that attitudes to debt have not changed very much across the economy as a whole. Although it's true that companies have de-leveraged, they've only managed to do so because someone else was kind enough to come along and take those debts away from them: and that someone else was a combination of households and the government.

Building a recovery on leverage is like building your new home on quicksand. It looks very good but it's in danger of fading from view rather too quickly. As consumers in particular begin to realise that they can no longer have their cake and eat it, the recovery is likely to look increasingly less robust. And that suggests that financial markets should be thinking not just about near-term increases in interest rates, but also reductions in interest rates in 2005. The Federal Reserve ultimately believes in risk management. It has no clear view of where interest rates are heading. Rather, it likes to make small adjustments in response to unfolding events. And that's why the "straight-line" approach to forecasting where interest rates are heading is wrong.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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