Interest rates may be going up sooner than many expect, and the implications could be far-reaching.
On June 21st a dove sounded a lot like a hawk. Andrew Haldane, chief economist at the Bank of England, a man who had been drawing all kinds of plaudits for his shrewd analysis of the economy and how it may be affected by technology, has long sat on the dove side of the Bank of England nest – known for his belief that the UK economy needs interest rates to remain at their record low level. But on that day, he appeared to change his feathers, sounding distinctly hawk-like.
“The risks of tightening ‘too early’ have shrunk as growth and, to lesser extent, inflation have shown greater resilience than expected,” he said, and added: “Provided the data are still on track, I do think that beginning the process of withdrawing some of the incremental stimulus provided last August would be prudent moving into the second half of the year.”
It has created a storm. The UK economy is not in the best shape right now. Real wages are falling, in Q1 economic growth was the slowest in the EU. Any conventional reading of such stats would suggest that the economy needs all the help it can get.
It is just that a few days earlier, the Bank of England’s monetary policy committee, (MPC) which is charged with the job of setting UK interest rates, came the closest it has been in years for voting for a hike in interest rates. The committee voted 5:3 in favour of keeping rates on hold. It is just that one of the votes in favour for leaving things as they are, was cast by Mr Haldane.
It is difficult to say for sure what is going to happen next, Kristin Forbes, who has been consistently voting for higher interest rates for some time, is stepping down from the MPC later this month. And the bank’s governor, Mark Carney, who has the deciding vote in the event of a deadlock, has made it clear he believes rates need to stay at their current level for some time yet.
There is no denying the mood shift, however. The odds of a rate hike soon seem to be shortening.
From one point of view, the logic seems clear. UK inflation rose to 2.9 per cent, in May, way above the Bank of England’s two per cent target, and since the pound has fallen since the UK election, it seems likely UK inflation will rise further. And since a hike in interest rates is the normal tool for dealing with rising inflation, it may seem like an open and shut case.
But then, the MPC is supposed to look through temporary shifts, such as currency fluctuations.
Meanwhile, in the euro area, inflation is falling back fast – the European Central Bank will surely be in no hurry to tamper with interest rates.
On the other hand, many believe that record low interest rates have distorted the markets – have fuelled a bubble in private debt, and propped up companies that under normal circumstances would have gone bust years ago. These are your zombie firms, the walking dead of the corporate world, that will crumble as soon as conditions return to some kind of normality – at least that is the argument.
The Bank of International Settlements (BIS) has been warning of a problem caused by low interest rates for some time. Claudio Borio, the BIS’s chief economist, has been warning that we are in danger of seeing a repeat of the 2008 crisis, as higher rates cause the bursting of the credit bubble. Today, the Telegraph quoted him as saying: “The end may come to resemble more closely a financial boom gone wrong, just as the latest recession showed, with a vengeance.”
Separately, the Telegraph quoted Eoin Murray, head of investment at Hermes Investment Management as warning of the consequences of the gradual reversal of quantitative easing, as central banks choose not to renew their purchases of bonds as original purchases expire. He said: “Like animals in captivity, companies incubated on the milk of QE and low rates may no longer exhibit the natural behaviours needed for success in the wild of a stimulus-free market.”
So, is that right?
It may all boil down to the question of whether interest rates are really artificially low. Are they at a record low because central banks have injected too much medicine into the system, or are they so low for other reasons?
If rates are too low, why does inflation remain so modest in the euro area and US – and frankly it is not so high in the UK. The fact that UK inflation is merely 2.9 per cent after ten years of record low interest rates feels pretty miraculous.
Maybe the real reason why rates are so low is that there is too much savings out there, partly caused by demographic shifts, as imminently retiring baby boomers save more, and as corporate profits appear to rise at the expensive of workers’ pay.
And if that is right, if there is what Ben Bernanke, former chair of the US Federal Reserve, calls a global savings glut, then rates may be set to remain low for the foreseeable future. And if the Bank of England votes to increase rates from 0.25 per cent to 0.5 per cent – which until a year ago was a record low – then that is no great shakes. The time to fret is when rates creep above three per cent, or close in on five per cent, and that may never happen.