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New Era? NAIRU Home |
Time to wake up from the 4% base rate daydream Anatole Kaletsky, The Times, 99-06-22 Inflation and the strength of sterling are both defying earlier expectations. Underlying inflation, instead of accelerating towards the top of the Bank's tolerance zone of 1.5 to 3.5 per cent, fell last month to 2.1 per cent. Many economists now believe that it will break through the bottom of the target range. The "headline" inflation rate, that includes mortgage interest payments, has fallen to an eye-popping low of 1.3 per cent. But before we get carried away with the idea that Britain is on the threshold of a golden era of almost free money and zero inflation unknown since the early 1960s, a number of factors need to be borne in mind. Looking at the charts, which analyse the interest rate expectations actually revealed by market prices (courtesy of Michael Saunders of Salomon Smith Barney), we can see that real-money investors are much less sanguine than theoretical economists about the prospects for British rates. As the top chart shows, three-month sterling rates are expected to rise steadily from 5.1 per cent to about 6.5 per cent by late 2001. Curiously, they are then expected to move down, defying the trend in interest rates on both dollars and euros. This long-term expectation, however, appears to have less to do with economic analysis than with a technical anomaly in the British financial markets. This aberration is revealed in the lower charts, which show market expectations for ten-year bond yields. According to these charts, investors expect yields on British government bonds to fall steadily, while yields on US and European bonds keep rising. By 2008, the British Government is expected to be able to borrow much more cheaply than the German or American Governments, paying less than 4.5 per cent for its bonds, while Germany and America have to pay more than 6 per cent. City expectations of further declines in inflation and interest rates in Britain are dependent on the view that the world economy will remain weak, flirting with recession and deflation. But this looks less plausible by the day. The American economy is, of course, booming - so much so that a tightening in US monetary policy will almost certainly be announced after the next meeting of the Federal Open Market Committee, on Wednesday week. But the chances that a quarter-point increase in US rates will halt or even retard the US economic juggernaut appear to be minimal. Consumers, businessmen and stock market investors may become even more bullish after a modest slap on the wrist from the Fed. Since the next meeting of the FOMC will not be until late August and since nothing more than another quarter-point tightening will be expected even then, the denizens of Wall Street and Main Street may well decide that the reality of monetary tightening has been less unpleasant than the anticipation. If anything, a modest increase in US interest rates this summer is likely to prolong and perhaps even accentuate the boom in the stock market and the consumer shopping spree. In the Far East meanwhile, conditions are manifestly improving and these economies have nowhere to go but up. Even Japan, which for the past two years has been the single most important deflationary influence in the world economy, is finally showing evidence of recovery. There may be scepticism about the 7.8 per cent annualised growth rate reported for the first quarter in Japan, but nobody seems to deny that the spending programmes initiated by the new Government, which took office last summer, are starting to deliver results in exactly the way predicted by Keynesian economics. Turning to continental Europe, the outlook for the global economy starts to look even more bullish. As in Japan, the worst of the recent downturn is clearly over. And while Germany may continue to suffer structural problems comparable to those in Japan, the rest of Europe now has the conditions in place for a strong, self-sustaining recovery in private consumption and investment demand. Amid the gloom that is still so prevalent about Europe's inflexible labour markets and its uncompetitive industrial structure, it is often forgotten that the main causes of Europe's low growth has been the macroeconomic mismanagement related to the single currency project. Much of Europe's unemployment has been caused by the tight monetary policies, rising taxes and overvalued exchange rates dictated by the Bundesbank in the run-up to EMU. Now that monetary union has occurred, some of the Bundesbank's macroeconomic errors have begun to be reversed. Interest rates, which should have been cut aggressively last year finally have been reduced to a level commensurate with Europe's economic weakness. Even more important has been the rapid devaluation of the euro since January. It would have been much healthier for Europe if this desperately needed devaluation had occurred before the euro was launched. But better late than never. Given the lags involved in the operation of monetary policy and currency devaluation, it is not surprising that the first signs of economic recovery in Europe are only now beginning to emerge. Piecing together what is going on in America, Asia and Europe, it is hard to avoid the impression that all the main regions of the world economy may be on the verge of a simultaneous boom. Anyone who remembers the last two such episodes - in 1994-96 and 1986-88 - will realise that this is not the first time that City economists have predicted never-ending reductions in interest rates and zero inflation. They were wrong then and they are likely to be wrong now. This is not the time to be dreaming of 4 per cent base rates. This is the time to be arranging a long-term fixed-interest mortgage. |