Cen­tral bankers should take plunge, raise in­ter­est rates

The Pak Banker - - COMPANIES/BOSS -

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.

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