DON´T BANK ON A COMFORTABLE INTEREST RATE RIDE / THE FINANCIAL TIMES MARKETS INSIGHT

Markets Insight

June 24, 2014 6:00 am

Don’t bank on a comfortable interest rate ride

By John Plender

Conventional wisdom has it natural interest rates have fallen

With debt in the developed world standing at higher levels than before the financial crisis, one of the more disturbing threats to financial stability is an unexpectedly sharp rise in global interest rates. That makes the current debate about what constitutes a “normal” interest rate painfully topical. The conventional wisdom has it that equilibrium or natural interest rates have fallen since the crisis, perhaps even on a permanent basis. If correct, the implication is that there is no cause for alarm when central banks start to raise rates. But is it correct?

Consider, first, policy rates. Over centuries these have been remarkably stable. The bank rate in the UK, for example, has averaged around five per cent since the Bank of England came into being in 1694. Admittedly, it is hard to argue with the widely held view that interest rates are going nowhere near five per cent any time soon, given that global economic recovery is weak and unsynchronised, while inflation in the developed world is under control.

That said, to conclude that policy rates are permanently lower would require convincing evidence of structural changes pointing to lower growth or a fundamental shift in savings and investment behaviour. This is not impossible. 

Changing demography could lead to slower growth in the labour force. The shift from manufacturing to services could bring about a permanent reduction in the level of investment, as could a decline in the rate of innovation. Yet this is speculative territory and there may be equal and opposite mitigating factors. An obvious case in point might be an ageing population leading to lower levels of saving.

The nearest I can find to a plausible case for a near-permanent downward bias to rates is a nightmarish one that comes from the economists at the Bank for International Settlements. They have long argued that monetary policy making both in the US and elsewhere has been dangerously asymmetric. Central bankers have failed to lean against booms, while easing aggressively during busts.

Vicious circles

This has led to a downward bias in interest rates and an upward debt accumulation habit. Vicious circles result, because it becomes difficult to raise rates without damaging economic growth. At the same time the distortions in production and investment behaviour induced by persistently low rates prevent a return to more normal interest rate levels. Low rates then become self-reinforcing.

I called this a near-permanent phenomenon advisedly. Clearly, it is vital for the sound workings of the economy for this not to be allowed to become permanent. Yet we are still in a post-crisis world where correcting the bias is simply not on the agenda. The all too obvious risk is that the economy becomes permanently beset by unending crises.

As for market-determined interest rates, the current story is one of excess savings, notably in the developing world, in the petro-economies and in the eurozone. What matters here is the potential for changes in savings and investment behaviour, above all in the US and China, whose economies are interdependent to an extraordinary degree. Here, too, there is a dangerous asymmetry.

As Stephen Roach, former chairman of Morgan Stanley Asia, has pointed out, Chinese officials regarded their 2008-9 fiscal and monetary pump-priming measures as a strictly one-off stimulus and are now trying to address problems of excess leverage, shadow banking and inflated property markets. While the economy has slowed, they have not reverted to stimulus as they seek to rebalance the economy away from investment and exports towards consumption.

The US, in contrast, is going back to the low saving, excess consumption growth model that prevailed before 2008.

Asymmetrical rebalancing

The outcome, says Mr Roach, will be asymmetrical rebalancing. While the US goes on as before, China will redirect its surplus saving to support its citizens and will have less left to support savings-short Americans. The flow of capital from China to the US will increasingly come from the private sector rather than via official reserves invested in US Treasuries. The implication is that Americans and especially the US government will find it harder to attract foreign savings. That points to higher interest rates.

Of course, Beijing may lose its nerve in the face of significantly lower economic growth and retreat from financial liberalisation and a commitment to current account liberalisation. Yet it has already had plenty of excuses to do that and held fast to date. It could be that the debt laden US and UK are in for a less comfortable interest rate ride than the conventional wisdom now allows. Certainly a view of interest rates that assumes this time is different should be accompanied by a historically well informed health warning.


The writer is an FT columnist

Copyright The Financial Times Limited 2014