The U.K., Eurozone and U.S. economies are all expected to see rising inflation in the next six to twelve months, prompting speculation of rising interest rates.
The case for raising rates occurs when an economy is overheating and inflation expectations need reining in. A higher interest rate makes capital more expensive and so moderates consumption and investment, and incentivizes more saving. Given the extraordinary phenomenon of quantitative easing, there are additional arguments for raising interest rates to more normal levels. It would seem to make sense that this process should start once economic recovery and inflationary pressure are in evidence, as indeed they are. Better still, they could be coordinated so as to avoid competitive devaluations and foreign exchange disruptions, though in the past synchronicity has often been achieved simply by other central banks following the lead of the US Federal Reserve.
What if inflation expectations are lower than actual inflation however? Whilst government bond yields have risen a bit, they are still exceptionally low and yield curves are not particularly steep, indicating that, collectively, markets see problematic levels of inflation to be little more than a distant memory. The success of overcoming deflation is thus to be met with a rise of interest rates to more normal levels and then staying low, with low/moderate inflation presumably for many years.
Yet we are forgetting two things. Firstly the buying of huge quantities of government bonds by a different arm of the public sector – the central bank – means that bond markets are distorted and yields may not reflect collective private market inflation expectations. Secondly, one of the purposes of policy is to reduce the real value of the stock of government debt through financial repression and negative real interest rates. In other words, having inflation a percentage point or two above interest rates is a policy objective, not a warning signal that interest rates need to rise.
It is the ability to persuade markets that inflation and interest rates are fine as they are which is the real magic, again assisted by QE, both by keeping bond yields low (through massive purchases of bonds) but also by allowing market commentators to lazily assume, as in the past, that if bonds yields are low this must reflect low inflationary expectations. If bond markets think inflation risk is low then inflation expectations can be contained. The result is wages and prices moving gradually higher in real terms at the expense of savers.
To give the impression that all is right with the world however, the concept of normalizing interest rates and exiting QE, albeit very gradually, has to be entertained.
It is also assumed by some that as and when interest rates do rise, gradually, exchange rates will be bolstered as such moves will be interpreted as signs of economic vigor and future growth – now these economies are on on their feet again after a long post-2008 recovery period. Then again, raising interest rates from infinitesimal to slightly more than infinitesimal does not strike many others as a sudden massive incentive to rush into these developed world bond markets, or for that matter, their equity markets. The debate over this is well established, and against the backdrop of existing bubble-level bond, equity, and foreign exchange values.
Markets are a long way from being efficient at the best of times. The pernicious effect of QE has yet another layer to it however. Because many investors have recognised the lunacy of investing in developed world bonds with next to no (or negative) nominal returns – and with significant yield and currency risks too – the investor bases in these developed world government bonds have become more and more concentrated. These markets are now dominated by central banks themselves and financially repressed pools of domestic savings effectively forced to buy their own domestic government bonds, either through regulation or as a result of a combination of overwhelming agency and incentive problems (it’s not their money) and being trained in the idiotic mysteries of asset allocation and so called risk management which dictates that such investments are “risk free”.
The homogenisation of the investor base also complicates the possible scenarios of what might happen should interest rates rise to more “normal” levels.
How might a “normalisation” of interest rates impact growth? As already mentioned, it might be interpreted as a sign of economic health and so, paradoxically, be stimulative. This however, will create more not less inflation, and in the new environment being sold as a return to normality, this will be more obviously a problem for central banks than at present. They may find that their modest one-off hikes need to be complemented by more of the same, maybe quite a lot more. The initially paltry extra return on bonds may not, as discussed, lead to any upwards currency surge either, so no help from FX markets in dampening inflationary pressures. Indeed, FX markets may quickly come to the conclusion that more interest rate rises are in the offing and so will stand on the sidelines for that reason alone, and may even put downward pressure on the currency, creating even more stimulus, and even more need for higher interest rates. Add the worryingly large quantities of government debt out there and bond market chaos could easily follow the initial economic optimism.
Bizarrely, if this happens, then more not less QE may be needed, possibly a lot of it in a hurry, in order to prevent a bond crash.
And remember the homogenous investor base? This poses the additional risk that if some of them, say foreign central banks, get spooked, they could cause further chaos, both in the bond and currency markets.
So, will interest rates go up soon? It’s a bit like a rickety go-cart hurtling (with a very heavy load) down a hill, but one with brakes on only one side. To the casual observer, who cannot see the dodgy brakes, it may look like the vehicle is under control. The driver wants to slow down by applying the brakes – it’s the obvious thing to do, and may work. But applying the brakes could quite easily cause a catastrophic unbalancing. What to do? So far the policy has been to hope that the bottom of the hill is near.
By Jerome Booth