Central bankers should take plunge, raise interest rates

Many major economies, including our own, remain perilously close to deflation, at least in consumer price terms (though asset prices are another matter altogether). China's decision this week to devalue its currency will export more price deflation to indebted consuming countries such as the UK.

There is a school of thought that says it is far easier to deal with the problems that low interest rates cause than it is to recover from the mistake of raising rates too soon and tipping an economy into deflation.

Higher interest rates will also increase costs: for homeowners with mortgages, for consumers with personal debt, for businesses and indirectly for the government, which must find tens of billions each year to pay the coupons on the UK's sovereign bonds. They will also strengthen the pound - bad for exporters.

But everything is relative. A bank rate of, say, 0.75 per cent would still be extraordinarily low by historic standards. Martin Weale, a member of the Monetary Policy Committee, has opined that there can be few businesses in the UK that are viable with rates at 0.5 per cent but would struggle with them at 0.75 per cent.

Furthermore, low deposit interest rates distort behaviour. They have forced savers to become investors. Those who might once have been content to leave some or all of their money in a bank or building society account have been pushed into higher-risk activities - from bond and equity funds, to peer-to-peer lending and crowdfunding, to "minibonds", to buy-to-let property.

"If you're considering income drawdown - or already in it - you'll know you need to control volatility. Any retirement brochure will tell you that reducing the ups and downs of your capital is the key to a stable income. They are right. You'd be surprised how quickly your money can run out if you need to draw an income from a dwindling capital pot. So far, that has had few unpleasant consequences because the prices of most assets have risen, driven by investors chasing higher returns than they can get on savings (Apple shares are up more than 500 per cent since July 2007, by the way). But the good times will not last for ever - and as Maike Currie pointed out last week, a lot of the investments being marketed to yield-chasers carry significant liquidity risk. You can get your money out of a savings account any time you like. It will take you months to sell a property.

The authorities have tried to mitigate the worst side effects of low interest rates - by lim- iting high-risk mortgages, creating schemes to help first-time buyers with the high cost of housing and launching savings products for yield-starved older savers.

Yet, however well-intentioned these initiatives may be, they just add another layer of distortion to what should be free markets. Another aim of ultra-low interest rates (and quantitative easing) was to stave off a freezing-up of the financial system. That objective has been achieved. They were also intended to encourage long-term investment. Here, the evidence is less clear. A lot of companies, especially in the US, have merely taken on very cheap debt - they can offset the interest against tax anyway - and used it to buy back their own shares. Financial engineering has taken precedence over investment.

This week we look at how to prepare for an interest rate rise plus how to make money from gold. And for the more adventurous investor, we examine the prospects for Chinese funds

Finally, there is the behavioural finance angle. Humans have a natural tendency to ascribe more importance to things that have happened recently than to events in the dim and distant past. So the longer that near-zero interest rates continue, the more that becomes the norm. A senior manager at an investment bank was quoted this week as saying that many of the younger recruits on his trading floor have not seen an interest rate rise in their adult lives. Central banker phrases such as "whatever it takes" and "as long as necessary" are increasingly taken to mean that rates will stay very low indefinitely in order to backstop financial markets

Back in 2009, when the interbank lending system was on the verge of freezing up, it was entirely appropriate for central banks around the world to send out the message that they stood squarely behind the financial system. Six years later and central banker phrases such as "whatever it takes" and "as long as necessary" are increasingly taken to mean that rates will stay very low indefinitely in order to backstop financial markets. In the late 1990s, this was termed "the Greenspan put", after the then-chairman of the US central bank. These days, "moral hazard" might be a better description.

The Federal Reserve is likely to raise its benchmark lending rate (for the first time since 2006) this year - possibly next month. It will be the most-telegraphed, most talked-about rate rise in history. That event will give the UK's central bankers the air cover they need to start the gradual process of restoring normal monetary policy in this country. They should take the plunge.