It's markets that rule the rates

Economics

A CUT in US and Japanese interest rates - and a sudden burst of sunlight spreads across the world's markets. There were further (though less significant) cuts in rates on Friday in France and Denmark, while here in Britain - quite aside from the surge in share prices as London followed the other markets - there came just the tiniest sniff of a cut, too. It is all an astonishing turnabout from the mood of concern a few short weeks ago when, far from there being any question of cutting rates, Kenneth Clarke clashed with Eddie George about the need to raise them. What's up?

The best place to start is with the reasons for the US and Japanese interest rate cuts, for they are very different. The US and Japanese econ- omies are at completely different points of the cycle. The US was the first into recession, the first out, and is now struggling to achieve what is usually dubbed a soft landing - ending the period of above-trend growth without plunging back into recession. The Japanese economy, by contrast, has hardly managed to pull out of recession at all, with only minimal growth and an ever-present danger of even that growth being swept away.

This different economic performance is mirrored in different interest rate experiences. The US has seen nearly three years of rising interest rates, and this cut of 0.25 per cent in Fed Funds rate to 5.75 per cent looks as though it may be the turning point when the cycle starts back down. Japan, by contrast, has seen ever lower rates, with the latest twist taking the Bank of Japan's cash rate to 0.8 per cent. (If both rates sound mouth-wateringly low, remember that they are the main rates at which the two central banks will lend short-term money to their respective commercial banks - ordinary mortals in both countries have to pay rather more.)

But both countries need interest rate cuts. Growth in the April-June quarter in the US may well have been negative, though obviously there are no figures yet. Meanwhile in Japan, there is something close to despair in the financial and business community as the falling stock market has undermined the financial position of the whole business sector and threatens bank crashes on the scale that hit America in the early 1930s. The parallel between the Wall Street crash of 1929-33 and the Tokyo one of the last five years is almost uncanny, as the graph plotting the two against each other shows. Indeed you could argue that the fall in Tokyo is worse in that until Friday the Nikkei index was still heading south, whereas by 1935 the Dow was heading upwards in a modest recovery.

So the rationale is clear enough; only the timing is surprising, for the US has moved rather earlier than the market had expected, while Japan has moved later. It was that surprise in timing that led to the strong market reaction.

But what is fun for global financial markets is not necessarily fun for British householders. Our own stock market is within a few percentage points of its all-time high, but neither our industry nor our home buyers show similar exuberance. So what does it mean for us?

There are, I think, three main messages.

The first is that we now have a decent signal, though not a conclusive one, that the US interest-rate cycle has turned. Don't worry about Japan, for yen interest rates are a law unto themselves, but there seems to be a sufficiently close relationship between the UK and US economic cycles, and hence sterling and dollar rates, to suggest that the turning point in UK rates will be within the next 12 months. Leave aside the debate as to whether the next move in rates will be up or down or whether, if it is up, there are one or two more rises in the pipeline. It must be a very high probability that by this time next year lower interest rates will have come through. Of course, they may come through very much sooner, but it is impossible to be confident about that.

This will have important consequences for the "feel-good factor". The weaker the economy through the autumn, the earlier the timing of the downturn in rates, so we should not assume that an early fall will signal an early upsurge in consumer or industrial confidence, still less a recovery in the Government's popularity. But come next year, the economic climate will be different. We may have to become more gloomy before we will be allowed to become more cheerful, but in as far as falling interest rates are usually associated with cheer, expect that within the next year or so.

Second, the fall in rates is starting from a much lower absolute level in the US than in the three previous cycles - as will be the case here. This is pretty self-evident and is just another aspect of the low inflation environment in which the world now lives: low nominal interest rates are indubitably linked to low inflation.

But even real interest rates in the US have risen less this cycle than in any cycle since the early 1980s. During the 1970s there were two dips when interest rates were negative - below inflation - and during the early 1980s the markets exacted a price for this cheating of savers by pushing real interest rates up to high single figures. Now it looks as though, in the US at least, this punishment is over and we can return to a world where real interest rates are in the 2-5 per cent region, as were nominal interest rates in Britain during the long period of price stability in the last century.

The implication for us is that while the days of absurdly cheap money in the 1970s, with interest rates below the rate of inflation, are over, so will be the days of very expensive money. Freed of these distortions, markets that are very sensitive to interest rates - such as housing - can get back to normal.

If this is right, the sensible expectation for house prices would be for reasonable price stability. Forget about another runaway boom, but also ignore the dire prognostications of another unremitting slump. Holders of homes with negative equity can expect to see their debt gradually cleared as most real incomes continue to rise.

The third message is the power of global linkages in financial markets. We have been educated to think of interest-rate movements being a political decision and to a modest extent that is true. But the range of freedom for action is very narrow. Had, for example, the Governor won that argument about rates a few weeks ago and base rates were half a percentage point higher, we would almost certainly be seeing a cut in the next few weeks: our scope for following the others down would be all the greater.

On any timescale other than a few weeks, our interest rates are set by the markets.

Interest rates are the principal weapon a central bank has against inflation. I suspect we are moving to a stage where inflation is determined not so much by governments but by wider economic forces. A suitably determined government could doubtless create some inflation if it really tried, but it is a lot more difficult than it used to be.

Moral: if you want assurance that inflation in Britain will stay low, look to the world's markets and not to people like Kenneth Clarke or Gordon Brown.