Friday, 13 September 2013

The Rate Debate Gets Interesting

Five years ago today Lehman Brothers the Wall Street Investment Bank went bust and for a few days the world held its breath to see what other banking titans might fall.  In the nick of time a new breed of super-hero was to step into the breach and save the day; central bankers arrived at the scene of the crash their pockets bulging with credit and cash for bail-outs and thank God they did.
Since the emergence of this new class of super-hero we have all be enthralled to the charms of negative real interest rates, quantitative easing and other creative policies for easing the money supply.  A new arrival on planet earth might be forgiven for thinking that messrs Carney, Bernanke and Kuroda actually are the people who rule the world and in fact they probably do!
Since their acts of daring do in the late summer of 2008 we have blithely allowed them to have it their own way, no one has stood in the way of the great credit easing and even small savers who rely on fixed interest products to provide income have gone along with the plan believing that a return to growth depends entirely on low interest rates and that growth is the sure way to rising returns.  The really rich have had no such problem they have embraced risk and high returns in the emerging markets and some pretty distressed debts in the developed world – Greek, Italian, Spanish and Portuguese government debt has paid out handsome levels of interest.

But there is now a change in the wind and Central Bankers have a new and fearless challenger – the markets!  Having spent five year obeying every command of the central Banks the markets are now dusting themselves off and their are spoiling for a fight.  As the hard as Central Bankers try to convince us that interest rates will remain low almost indefinitely the markets are whispering a different message in our ear – rate will rise (rates are rising).  Last week the UK’s long term interest rates rose above 3% for the first time in years.  But should we be worried by rising interest rates now?

Simplistically rising interest rates will be good and bad news for individual depending on which side of the balance sheet you happen to be – creditor or debtor. Yet as far as the economy as a whole is concerned the question is somewhat complicated.  On the face of it rising long-term interest rates are simply an indicator of the growing confidence investors have in the US and UK economies, so this is good news.  The bad news is that these rising rates might choke off recovery and send us spinning back into recession and into the jaws of the dreaded liquidity trap (where a shortage of demand drives the economic recovery in reverse).  Into this fairly simplistic black and white argument there are a number of complicating factors that make things really interesting.

The first of these factors in timing, depending where you are in the economic cycle rising interest rates can be positive or negative.  The US and the UK are close to the point in the cycle where rising interest rates would be helpful in controlling inflation (particularly house prices in the UK).  Also it would give more encouragement to savers to help re-balance the economy away from private and public debt;  Governments and the private sector have little incentive to become less indebted whilst real interest rates are negative. Timing is also important in terms of setting the eventual high point for interest rates – the earlier you start the lower the peak rate will be; albeit if one starts too early one would risk a reverse into recession.

The next factor is the relative position of our economy compared to the competition.  In the UK our global competitors particularly those in Europe are in a relatively poor position; whilst raising interest rates in the UK would have very little impact on us it would probably damage our competition (good news)  as we would sucking more investment capital and forcing their interest rates higher.  This would improve the strength of our currency, improve our productivity, creating a virtuous circle where overseas investors would want to increase their investments here rather than in the US or Europe.

The final factor to weigh is the type of economic activity you are trying to encourage, if we want to protect our existing industrial and commercial base we probably should hang onto low interest rates for as long as possible.  A by-product of this risk adverse approach is that we will be surrounded by zombie companies that survive only because of cheap money without the energy to grow profitably, these companies soak up human and financial capital suppressing growth and reducing our global competitiveness.  If we want an economy that is going to discourage smokestack industries and puts the emphasis on high margin growth we might well think higher interest rates would be sympathetic to these goals.
We need a brighter future 

So to conclude it’s really about confidence and our vision for the future (something this government doesn’t seem to have).  If we believe in ourselves and that a sensible level of interest rate maintains a competitive market for capital we should be in favour of positive real interest rates.  If we also believe that we are at the forefront of the global recovery we should probably raise our rates before others do.  And finally if we want to remain the destination of choice for foreign investment we should also raise our rates so they can be sure that their investment and profits will be secure in a strong economy and currency.

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