|The hangover after too much punch
Interest rates are on the rise around the world and we will all be
feeling the pain
Larry Elliott, economics editor
Monday August 7, 2006
THE SURPRISING thing about the Bank of England's decision to raise
interest rates was that it was a surprise. There were plenty of straws
in the wind in the past month to suggest the monetary policy committee
would opt for a no-risk strategy, yet the City - with a few notable
exceptions - failed to see it coming.
In one sense the move was entirely predictable. The Bank raised rates
by a quarter of a point in August 2004 and kept them unchanged for a
year. The Bank cut rates by a quarter-point in August 2005 and kept
them unchanged for a year. It's now August 2006 and, guess what, the
MPC has emerged from its year-long hibernation to raise rates by a
quarter-point. Any bets on when the next change in borrowing costs
Last week's decision, however, was based on more than just habit.
Interest rates are going up around the world. The European Central
Bank tightened policy on the same day as the MPC; the People's Bank of
China is putting the brakes on the world's fastest growing economy;
the Bank of Japan has just ended a long period of zero interest rates
designed to tackle deflation; and the Federal Reserve has ratcheted up
the cost of money in the United States by a quarter-point at each of
its last 17 meetings. The 18th successive increase may come this week,
depending on whether the Fed is more concerned about rising inflation
or weaker growth.
What concerns central banks is that there is far too much easy money
sloshing around in the system. Interest rates were cut and kept
unusually low for a prolonged period earlier this decade amid fears of
recession. It became a lot cheaper to borrow and this meant consumers
could ramp up their spending and businesses were encouraged to invest.
It also meant more speculation in property and in financial markets,
and a greater vulnerability for borrowers when interest rates started
to rise. Last Friday's bankruptcy figures in the UK illustrate the
point. The number of people going bust has reached record levels; the
figure is on course to hit 100,000 this year for the first time. The
big high-street banks made a song and dance last week, but it is the
banks themselves that are to blame for nurturing the live-now,
pay-later, have-it-all culture with their aggressive marketing and
We will see in the coming months just how many individuals in Britain
are living on the edge, with only modest increases in rates enough to
tip them over the edge. My guess is that the economy is far more
sensitive to a quarter-point rise in borrowing costs than it was,
especially if there is a threat of further moves from the Bank. The
fact that insolvencies were 66% higher in the second quarter of 2006
than in the second quarter of 2005 is a sign of just how tough many
people are finding it to meet their financial commitments; add in
spiralling energy costs, rising unemployment and higher interest rates
and you have the recipe for extreme difficulties for many households.
The same applies, perhaps even more so, to the US, where debt levels
are even higher; the Fed has raised interest rates from 1% to 5.25%
and activity in the housing market is weakening fast. With oil prices
likely to stay high and, as Friday's payroll data showed, jobs
becoming harder to find, it is difficult to envisage anything other
than a marked slowdown in consumer spending on the other side of the
Atlantic for the rest of 2006 and into 2007. And that would have
knock-on effects everywhere else.
There are those on Wall Street - although their ranks dwindled after
the payroll data on Friday - who think the Fed will take out an
insurance policy against rising inflation and push rates up to 5.5%
before taking a breather. There are those who think they have already
called it a day. Either way, the sense is that the peak of the US
interest-rate cycle is close at hand.
That, paradoxically, is why any data that any normal person would see
as bad - rising unemployment, for example - is seen by Wall Street as
good. Why? Because rising unemployment means the economy is getting
weaker. If the economy is weaker, that means lower interest rates are
on the way. And lower interest rates are good for share prices.
All this strikes me as a bit complacent, for three reasons. The first
is that central banks may be more concerned about inflationary
pressures than the markets think. If, for example, core inflation
continues to rise in the US, then the Fed may keep raising rates, even
if the economy is coming off the boil. The same applies to the MPC and
the other central banks, which are likely to put any coming global
slowdown into context. There has not been faster global growth than
that seen over the past four years since the early 1970s, so some
easing back is only to be expected.
The fact that the tripling of oil prices has had so little effect on
growth may reinforce the feeling among policymakers that they
overcooked things by leaving rates low for so long.
The second point is that markets have a naive belief in the
infallibility of policymakers. This is ironic, given that the
prevailing philosophy among policymakers for 25 years has been in the
infallibility of markets, but there we are.
As Ian Harwood, of Kleinwort Dresdner, pointed out last week,
policymakers do not always get it right; he cites the premature
tightening of policy in Japan in 2000 as an error that had
far-reaching consequences. Potential banana skins for the future
include the VAT increase planned for Germany early next year and the
Fed waiting too long before easing policy in the US.
But there is a third difficulty. Assume the markets are right: the
tripling of oil prices does have an impact; the Middle East remains in
turmoil; central banks have timed to perfection the moment to remove
the punchbowl from the party; growth slows everywhere and inflation
abates. And then what? Presumably, the whole dreary cycle starts
Since only cheap money can persuade consumers to spend and businesses
to invest, interest rates come down. Liquidity is pumped into the
banking system; our doormats are once again carpeted with unsolicited
mail extolling the benefits of taking out fresh lines of credit at
"unbeatable" rates. Debt levels go up as the cheap money fuels a new
bout of speculation. And when the speculation reaches fever pitch,
central banks hose things down for a while.
Perhaps I'm missing something here but it seems that this way of
regulating economies is just as crude and inefficient as the old
system of direct controls on credit - and potentially far, far more
destabilising. This is not economics, it is bubble-onomics.