Muddled market thinking on rates

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The Independent Online
THERE is another rise in interest rates on the way.

That was the easy part, now for the harder questions. When will the next rise happen? How big will it be? How many more such rises will there be? What will be the peak of the cycle? And when will that peak be reached?

It is easy to predict that there will be another rise in rates fairly soon for three main reasons. First, there is sufficient evidence of rising inflationary pressure in the UK to justify at least one more rise. You can see this pressure in a variety of places, but it is most evident in industrial costs, which in turn have been affected by the combination of a jump in commodity prices and the decline in sterling.

There is no inflationary catastrophe out there, but as the Bank of England's most recent Inflation Report warned, some further rise in inflation is likely, and the balance of the uncertainties is that over the next two years inflation will be higher than its central forecast rather than lower.

The second reason for expecting an early rise in rates is that the fall in sterling in recent weeks has had the effect of loosening monetary policy. Ordinary householders will not have noticed this - we do not find that our mortgage rates are coming down - but any company in the export business will have done so, in that the fall in sterling makes exports more profitable or, insofar as the exporter cuts prices, increases demand. The opposite effect happens on imports: they become more expensive and we will tend to buy fewer. So a fall in the exchange rate has the same overall effect of boosting demand, though it takes place in a slightly different way from a fall in interest rates. The rule of thumb is that four percentage points off the exchange rate is equivalent to one percentage point on interest rates. Since the pound has fallen by three or four points since the last rise in rates there is, on the face of it, a case for at least another half a point on base rates.

The third reason is that the world interest rate cycle is also turning upwards. There is a great debate going on in the United States at the moment as to whether there will be another rise in US rates, but the balance of probability is strongly that there will. Most continental European rates will certainly rise, though it is just possible that there could be one more token cut in German rates before they, too, start to climb. In the world of the international markets no country is an island: rises in rates elsewhere will tend to push ours up, too.

When will the next rise be? My own guess is quite soon: within the next six weeks. In theory, changes in interest rates are decided at the monthly meetings between the Chancellor of the Exchequer and the Governor of the Bank. The timing of the implementation of the move is left to the Bank. The next meeting is on 5 April, which is an obvious trigger for a change. But there may be some leeway for a move following the March meeting, the minutes of which are not published until mid-April. So an earlier rise is not out of the question, particularly given the Bank's desire to pre- empt the market by moving quickly.

How big will the rise be? Half a percentage point, unless there is a new and more serious bout of currency instability involving sterling as well as the dollar. Were that to happen, it is conceivable that we would increase rates by a full percentage point as part of an international package involving a similar rise in the States and a cut of rates in Germany. But this is very unlikely.

How many more rises will there be? Probably two. While it is just possible that one more rise in base rates will be seen to be enough to head off inflationary pressure, the market certainly does not think so. And how high will the rates go? Assuming the rises come in half per cent jumps, one would take base rates to 7.25 per cent, two to 7.75 per cent. And when will the peak be reached? Middle of next year.

Of course that is guesswork. It is guesswork with which the markets would not agree. The graph on the left shows what has been happening - and what the market thinks will happen - to three-month market rates over the 10- year period between 1987 and 1997. (These money market rates are a better indicator of the real price of funds for commercial institutions than base rates, but they are a fair proxy for base rates as the two are in line with each other.)

The mainstream City expectation is for money market rates to rise above 9 per cent. If that were right, this rise would have to be validated by several more rises in base rates and the peak would not come until well into 1997. By recent historical standards that expectation of the next peak in rates would not be very high: not much above the trough of 1988. But even that seems too high. The Goldman Sachs expectation, the lower projection on that graph, seems much more realistic, and I would go along with that.

My main reason for so doing is demonstrated by the graph on the right. Three-quarters of the run simply shows what has happened to inflation in Britain since the end of the First World War. Aside from the extraordinary swings at the end of that war, and quite a long period of falling prices during the inter-war period, the real oddity is surely the time between 1970 and 1990. It was a period of peace, yet the inflationary performance was worse than at any other time for 70 years. Moral: the high interest rates of that period were an oddity too.

Now look at the inflation projection. It is not an official one (though it comes from the Bank's Inflation Report. It is simply the inflation rate "predicted" by prices of gilts. Buyers can choose between gilts giving a specific fixed return, maturing at a known date, and index-linked gilts, whose return will be determined by future inflation. By comparing the two you can work out what the market really thinks about the future of inflation. The answer (taken from market prices at the beginning of February) is that inflation will peak at just less than 5 per cent in 1997 and will then fall gradually to 4 per cent by 2010.

Let us assume that is right (although I happen to think that it is far too high). If inflation is not going to rise above 5 per cent it is very difficult to justify short-term interest rates at more than 9 per cent.

You should not need to offer a positive real return on cash of more than 4 per cent. The only situation that might justify it would be to choke off an unsustainable boom: the sort of circumstances that ruled in 1989/90.

So these market expectations of a peak in rates of 9 per cent by 1997 will only be validated if there is a runaway boom between then and now.

Look at the house market; look at the still-muted earnings growth; look at the fact that the markets are worrying about inflation when the underlying rate is only just over 3 per cent. Surely the prospect of a runaway boom is for the birds.

Yes, there is another interest rate rise on the way soon. But the fact that it will be soon is itself one good reason why householders can expect base rates to peak at less than 8 per cent.

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