Even governments have to bow before the bond markets: National anti-inflation strategies are increasingly globally led, explains Hamish McRae

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The Independent Online
THE INTEREST rate rises are not just a British business. Rates around the world are going up, and the half-point increase here is just one more piece in the global jigsaw. Our reactions to the announcement yesterday are still rooted in the attitudes of the Sixties and Seventies, but its timing and nature tell us something about the world of the 1990s.

Crucially, monetary authorities around the world still have some control over short-term interest rates - these are their principal weapon against inflation. But they have virtually no control over long-term rates, that is, the rate of interest at which governments and large companies borrow for periods up to 30 years on the world's bond markets.

The fact that short-term rates rise at the first sniff of rekindled inflation shouts that we are in a world of stable prices and we had better get used to to it.

The US economy was the first of the large developed countries to pull out of recession and, unsurprisingly, the first to push up short-term interest rates, in February. The UK was the second to recover and is following suit now that it is more than two years into growth. A resurgence in Germany at last seems secure, and so it looks pretty clear that interest rates there will rise within three to six months, maybe in three to six weeks. That will pull up other European interest rates. And finally, but probably not until well into next year, Japanese rates will rise too.

All this is natural, normal and inevitable. Yet we still talk of it as though the decision to increase rates was solely the result of a powerful discretion exercised by the Chancellor and the Governor of the Bank of England. According to the political or professional bias of the commentator, they were being either prudent or pig-headed.

Professional interpretations of interest rate movements depend on whether the commentator is representing borrowers or lenders: thus the CBI thinks interest rate rises are bad because it represents companies, which are generally in debt. If pensioners living on their building society savings had a similarly articulate professional body they, conversely, would be cheering.

The classic political response is a ritual dance dating back to the days when governments could, within broad limits, make decisions that mattered about interest rates. Those were the days when there were exchange controls, when lending by banks, hire purchase companies and building societies was regulated, and when international borrowing and lending were tiny.

All this is now history. There is some modest measure of discretion about the timing of interest rate changes, but the scope for such discretion is very narrow. British interest rates were bound to rise within the next three or four months, and they were bound to rise by either a half of one per cent, or by three-quarters; all that has happened is that they have started to go up a few weeks earlier than most people had expected, and (partly because the authorities chose to go early) gone up by the minimum rather than the maximum.

The underlying reason for this early response is that the markets want it and it is safer for policymakers to give them what they want. Governments have some control over very short-term interest rates - the rates on money borrowed for a few months. But the longer the period for which money is borrowed, the less control governments have. In the case of money lent for 10 years or more, they have hardly any.

You can see this best by looking at the US. In February this year the Federal Reserve increased short-term interest rates to show its seriousness in fighting inflation. But the upward move in long-term rates, driven by fears of inflation, had already started the previous November. Any rise in rates has the effect, for anyone holding bonds, of devaluing the price of their existing holdings. So the US long-term rate rise then developed into a world-wide collapse of the bond market.

The reason for this collapse is still not fully understood, but it clearly has to do with expectations of inflation (why lend for 30 years at a fixed rate of, say, 6 per cent, when governments might inflate annually at 5 per cent?) and it has something to do with the sheer scale of public borrowing (last year total world borrowings on the bond market, mostly by governments, were roughly pounds 1,000bn, of which we were responsible for 5 per cent). But it is probable that had the Fed moved earlier to increase short-term rates, the rise in long-term interest rates would have been less marked.

You can see the results much closer to home. Early this year, before the US bond crash had gathered pace, all the big banks and building societies were offering cheap fixed-interest mortgages. At one stage these accounted for two-thirds of all new mortgages. Then they suddenly dried up. Our own short-term interest rates, which caused the fuss yesterday, did not move at all, nor did the headline mortgage rate. But the practical effect of the world bond crash was to make it harder to borrow at a secure rate to buy a house in Britain.

What happens next? The Chancellor and the Governor clearly hope that by putting up short-term rates now and thereby showing their keenness to check any rise in inflation before it happens, they will curb any further rise in long-term rates. If they are successful, yesterday's action could be positive for growth prospects: by making borrowing very slightly more expensive for people and companies wanting money for short periods, they might make it cheaper for anyone wanting to invest for the long-term.

That is what, in theory, should happen. But there are two gulfs between theory and practice. The first is that whatever we do in Britain with our policy, sensible or stupid, we are at the mercy of international events. If inflation around the world appears about to rise then the markets will continue to push up long-term interest rates world- wide. We will suffer along with everyone else. For a few months yet there are price pressures on the horizon, so the only practical response will be for governments and central banks to continue to push up short-term rates. If they do not, the bond markets will punish them.

The second gulf is that Britain, in the eyes of world investors, is a reformed alcoholic as far as inflation is concerned. Though recent performance is good, we have a poor post-war record. We will not be trusted until we have been through a couple of economic cycles without more serious inflation than the US, Germany or Japan. Just listen to the way this rise in rates is being attacked and you can see why we are not trusted. The whole business of giving the Bank or England more authority is an attempt to gain credibility for fighting inflation.

And there is the rub. We have to establish a low-inflation environment whether we want to or not: the penalty for failure will be higher and higher long-term interest rates. That reality is being imposed on us not by our politicians nor by the Bank of England. It is being imposed on us, as on every other industrial country, by the world's bond markets, where true power lies.

(Photograph omitted)

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