When Will Interest Rates Rise? We’re in a Trap, and It’s Going to Get Ugly
The Bank of England
In an age without Western wars, the analogies of the battlefield are commonly appropriated for the more mundane.
From the safety of the workstation, the government “combats” climate change, “fights” prejudice, “declares war” on drugs and “battles for Britain” at the negotiating table. Forgive, then, my opening of this article with a quote which is equally pertinent now that the desk-top generals of the Fed and the Bank of England are facing the fight of their lives as it was in World War II. Winston Churchill said that “Battles are won by slaughter and maneuver. The greater the general, the more he contributes in maneuver, the less he demands in slaughter.” This applies equally to the more mundane world of money supply and interest rates. To see why, we need to draw on another analogy which has cropped up far more frequently since the advent of the financial crisis – that of the drunkard.
Central Banks have a duty to take away the punch bowl before the economy becomes roaring drunk
William McChesney Martin, the chairman of the Federal Reserve Board between 1951 to 1970, was the first to describe his role thus: “I’m the fellow who takes away the punch bowl just when the party is getting good.” What he meant was that as the economy grew, the velocity of money through the system picked up and prices started to rise. The Fed’s job in those circumstances was to apply a coolant in the form of increased interest rates. To extend the drunk analogy, the time to stop drinking was after a short drink of lower rates was enough to ensure that conservative markets had lost their inhibitions, but before they had lost them to the extent that they were liable to lose the shirts from their back. However frequently the punchbowl analogy has been cited by central bankers testifying before Senate or Parliament since the crash, Mr Martin’s example is not one which has been followed in modern times. The effects of continuing loose credit before the great crash of 2007 – 2009 had a profound impact on economies across the West. While in America it fed the sub-prime boom, with borrows allowed to take on credit commitments for housing which they were unable to meet, a similar phenomenon occurred in Britain with the advent of 100% or even 105% mortgages which left the borrowers exposed were the economy to embark on any course other than sustained, linear growth. As concerning was the advent of large personal debt accounts in many households – in the UK alone £1.01 billion of personal debt is currently being written off each day by banks and building societies as not recoverable given the financial straits of the borrowers.
This growth in credit beyond historical norms needs to be understood in the context of its future effect. Borrowing essentially acts as a sacrifice of future consumption in return for present day gain. In some circumstances this is justified. Taking a loan to build a small business, for instance, can be seen as an act which will amplify future returns by moving consumption to the present. Likewise a household borrowing to renovate a property can argue that they will be able to realize a greater gain in future thanks to spending up front. However, when debt is used on consumption of goods with little or no future value then the effect is to constrict all consumption in future as future revenue has already been constricted. In economies like Britain’s, heavily dependent on consumer spending for GDP growth, the natural impact of a credit binge is a severe, long-term slow-down in economic growth while those debts impact upon household finances. To return to the drinking analogy – failing to take away the punchbowl at the right time means a much greater hangover the next day, and less productivity at work, compromising future career progression and financial well-being.
Central Banks have painted us into a corner with their low interest rate policies
None of the above is particularly controversial. The response of central banks to the situation is, and, I would suggest, will come to be understood as intensely misguided. A hangover is nature’s way of punishing over-indulgence. In the same sense, the depression in a financial system in the years following a debt binge acts as a warning, requiring the economy to rebalance away from credit fuelled consumption spending and to concentrate on investment.
In keeping with the wider trend in the West towards thinking of personal responsibility as something which may be comfortably outsourced to the government of the day, central banks have been determined that the lessons of the past should not be learnt. Global markets are booming, the loose money which has been created to shore up the bond markets is being used by banks to fuel a rally in assets which as seen the S&P 500 rise from a low of 676.53 in 2009 to 1,793.43 at the time of writing. This rise to 265% of trough value has taken place in the context of US incomes continuing to fall as a proportion of GDP to a 13 year low in August 2013. If ever there was a set of circumstances demanding that a central bank withdraw the punchbowl and allow the markets to draw some breath, it would be these. And yet, the opposite is occurring on both sides of the Atlantic. In September, the Fed withdrew from its long-trailed intention to taper, fearing precisely the calming impact on markets which such an action ought to have. In the UK, political imperatives have seen the credit markets go a step further. The Government’s mortgage guarantee scheme aims directly at bolstering the borrowing opportunities available for sub-prime borrowing. Those uncharitably inclined may also see a similar motivation in the putative scheme to cap interest rates charged by payday loan companies – the failure to impose a German style outright ban on usurious rates is a tacit admission that these are now an essential part of the lending mix. Even though Mark Carney has made a great show of cutting the housing element of Funding for Lending, the impact from January onwards of the new lending guarantee negates the limited effect which this will have (the programme was already heavily skewered towards business). Taken as a whole, the response of monetary policy actors to the difficulties presented by the financial crisis has been to double down on the old methods. Far from central banks taking away the punchbowl, they are lacing it in response to the terrible consumer hangover from the last night’s binge. The result is that a problem which could have been rectified with a one-off dose of pain has now become chronic – the modern economy now has a structural dependence on loose money, and that severely limits the capacity of central banks to react to adverse effects elsewhere.
The economy is vitally dependent on low interest rates and loose money — there is no room for maneuver
Because the addiction to loose money in the financial system is so strong – underpinning asset prices, inflating consumer sentiment and spending, removing risk judgments from the investment process – the room for maneuver which has normally been a staple of central bank planning has evaporated. Irrespective of whether rate rises are needed to rescue savers, realign risk and return ratios or, most probably, to fight inflation, they will have the force of blunt instruments when they are raised. As for cutting them in the case of an emergency, there is nowhere left for them to go short of fining banks for keeping cash on deposit. The central banks have very limited room for maneuver, and with that lack of wriggle rooms comes a much greater possibility of financial slaughter.
It is important to place this prospect in the context of what has happened to household incomes in both Britain and America over the past five years. In both countries, real wages have fallen slightly for the median household. At the same time, true cost of living inflation has continued its exponential rise (although this has been largely hidden as a result of changes to the weights and measures used to capture inflation. By the 1979 measure, UK core inflation has been at 8% or greater every single year since that date). While the inflationary pressures in America are easing thanks to the extension of the shale energy boom’s benefits, this is not the case in Britain where stubbornly high energy costs have been bolstered by the government’s determination to hold down Sterling. In Britain particularly, the only factor which has allowed households to keep their heads above water has been the reduction in mortgage rates as a result of what amounts to a zero interest rate policy. The extension of the inequality gap over the course of the recession can partly be traced to this. The poor have seen living costs rise 25% over the past five years, yet at the same time if they are not wealthy enough to buy, they have not, unlike the middle classes, been in a position to reap the benefits of falling mortgage rates (which benefit even that 70% of the population on fixed term deals over the long-run as these deals have break and extension clauses which roll around at least every five years).
A rise in interest rates will therefore have a dramatic impact in the real economy. The civil service pay freeze, however badly enforced, will continue until the 2015 election in Britain and possibly beyond should the Coalition triumph again at the polls. In the private sector, conditions are improving but the market is simply not creating the volume of high grossing opportunities as it did before the crash. In 2013, the larges bulge-bracket banker intake at a graduate level for the front-office was 40. Prior to the crisis, the average per bulge-bracket was in the region of 300. In a jobs market which is so stagnant, employers hold the whip hand. It is no surprise that for the country as a whole, wage rises have now been outstripped by inflation for five consecutive years. Once rates rise, the crisis in the cost of living which has been partly masked by falling mortgage payments and an increase in asset prices will start to bite beyond the bottom quartile, with a knock-on effect elsewhere. The impact of the increase in the repayments required to service mortgage debt will be augmented by the impact from a fall in asset prices when interest rates finally rise.
One of the long-term consequences of loose money is to disincentivise risk management in investment. By ensuring that there is always a negative risk-free return from savings once inflation is taken into account, central banks have pushed the flood of loose money they have created into assets. Once interest rates rise, so will returns from low-risk financial asset management approaches, like holding cash. This will trigger a move out of stocks and bonds. As these prices fall, households will feel materially poorer. What happens from this point is disputable. Households feeling poorer ought to cut back on non-essential spending, clobbering growth.
There is, however, a counter-argument. So far, the inflationary effects of loose money have been entirely confined to the asset markers. It could be thought that when these positions are monetized, and the paper gains turned into cash in accounts, then this will be hugely inflationary in the real world. If that happens, the central banks would be forced to raise rates again, creating a vicious cycle. The astonishingly foolish decisions of incredibly clever men and women is one of the great motifs of our times. I suspect we will maintain zero interest rates for as long as possible, given the difficulties which rate rises bring with them. Every month that goes by, however, digs the hole deeper and limits our room for maneuver even more. In attempting to attempt to consequences of our actions initially, we have merely ensured that when they arrive, their impact will be ferocious. It often feels as though central banks are attempting to re-write the rules of economics as they go. Perhaps they will be successful in that endeavor, but I am reminded of an old canard from physics when I contemplate current policy: every action has an equal and opposite reaction. Pretending our actions are consequence-free is a mug’s game, but like it or not, it’s one we are all being forced to play.