commissioner.org
| Source | Jim Devine |
| Date | 06/08/08/01:10 |
| 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 Guardian 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 will be? 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 irresponsible lending. 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. Slowdown 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. Overcooked 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 again. 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. Larry.elliott@guardian.co.uk |
Copyright (c) 1998, Joongpil Cho