Longer-term interest-rates will determine much of what happens in 2011 in the UK and abroad

After signing off for Christmas with a reference to the fact that some years Japan likes to make economic changes over the holiday period I have to confess that it had not occurred to me that China might have been watching this policy with some admiration! Imitation being the sincerest form of flattery should have led to the Japanese being rather flattered on Christmas Day when the Peoples’ Bank of China announced this ( with thanks to Google translate).

People’s Bank of China, from December 26, 2010 from financial institutions raised the benchmark deposit and lending rates. The one-year deposit and lending rates by 0.25 percentage points, respectively, other deposit and lending interest rate adjusted accordingly.( The report does not make this clear but the rates rose to 5.81% and 2.75% respectively).

Rather oddly some economists had begun to speculate that China would not raise interest-rates at all in a rather odd demonstration of ill-logic. The plain truth is that with commodity price trends as they are the Chinese find themselves in a position where they are suffering from first as well as second-order inflationary effects and accordingly this will be by no means the last interest-rate rise they make. By first order inflationary effect I mean that China is one of the forces driving commodity prices higher which then has inflationary effects on her. By second-order effects I mean the way her property prices have risen in response to a booming economy. It is not possible at this stage to say how many interest-rate rises will be required because much of the future is unknown but if history is any guide it is likely to be more than market expectations.

The early part of 2011 may be very revealing in this respect as due to the seasonal nature of food production there is a danger of further price rises in January and February. We also have to remember that China is not only raising the price of credit by raising interest-rates it is trying to reduce the supply of credit by raising bank reserve requirements. Personally I find the latter move fascinating as many other countries abandoned such a policy quite some time ago (mostly because it did not work…..) and if you consider the position logically it is hard to avoid the thought that modern advanced financial markets are likely to be able to weave their way around such rules even more effectively that their predecessors did. Let me use a word that has been out of use for a while disintermediation. The definitions on the web of this are not helpful so let me explain.

Disintermediation occurs when monetary activity moves from a controlled aggregate to an uncontrolled aggregate. This leads us to feel a policy is working when in fact you end up measuring the wrong thing. In the UK the measurement of £m3 as a monetary aggregate in the 1980s was a clear example of this.

Longer-term interest-rates and their impact

Official Interest-rates explained

If we start with a definition of an interest-rate as the price of money we have what is a reasonably simple and clear concept. This is a point where much analysis stops and,in my opinion this is a mistake. If we now move to what most people regard as the interest-rate and look at it for the UK then we get an example of why I think that analysis should go further. According to a Bank of England working paper it does the following.

The Bank manages its balance sheet with the objective of maintaining overnight market interest rates (the rates at which banks transact with each other) in line with Bank Rate, so there is a flat risk-free money market yield curve to the next MPC decision date, and there is very little day-to-day or intraday volatility in market interest rates at maturities out to that horizon.

If we put that into plainer English they only control overnight interest-rates. There is a secondary effort to control interest-rates of up to a month (to avoid embarrassing themselves between MPC meetings but in truth that is mostly only a function of controlling overnight rates). So there you have it in essence overnight rates only. This leaves us immediately more uncertain as there are quite a lot of deals which depend on a longer term for example mortgage-rates, commercial borrowing and the governments own borrowing.

The Term Structure or maturity spectrum

What happens as we move away from the officially set overnight interest-rate and move onto longer-term interest rates tells us a lot about the state of economic policy in that country. For example in the UK the official overnight rate is 0.5% and if we look at the one-year borrowing rate for the UK  it is not much above this indeed you have to go into 2012 to find a UK government bond with a yield of over 1%. Whereas if we look at Ireland where the official interest-rate is the Euro zone 1% we find she has an eleven month bond which yields some 4.18%. What this expresses is that the UK retains control and influence over the term pattern of her interest-rates and Ireland does not. One could do a similar analysis for Greece with the same answer as Ireland.

Further out along the curve

As we move along the maturity spectrum then we get other influences at play. Over the longer-term as we move towards the ten-year maturity area we see factors such as inflation expectations and future economic prospects come into play. Higher expected inflation usually leads to higher yileds as in normal circumstances does an improved economic forecast. However these are not normal times and because many countries are borrowing large amounts after the credit crunch we may well find that improved economic prospects may lead to bond yields falling.

Why does this matter?

If we start with the view that longer-term interest rates influence the housing market via mortgage costs as they must influence fixed-rate mortgages and also will influence longer-term variable rates we have a reason for looking at them. We can also add to this that companies borrow over periods much longer than the official rate and so for these too the importance of the official rate is reduced. Indeed we can come to a conclusion that market rates are usually more important than the publicised official rate. Personally as I have written often on here the way that unofficial interest-rates have diverged form the base rate means that it is fast becoming an irrelevance. For example if you look at UK savings rates you can get 3% and surveys of overdraft rates seem to be around 19%.

As we go forwards this will become a factor for our government too because it will find that as it borrows more and more then it will find that  longer-term interest-rates will increasingly influence its thinking.So far we have only seen the impact of us borrowing more. For example in this financial year the debt management office expects us to have to issue some £162.5 billion of gilts of which £125 billion or so is new issues. Should they all have been ten-year maturities at current interest-rates would cost some £4.4 billion a year. However tucked away is a factor probably ignored the recent rise in longer-term interest-rates represents some £750 million a year…

Conclusion

Here is a real danger for governments and their fiscal forecasts. We know that most countries have to borrow a lot of money and that this in itself will lead to a rise in debt costs for them. What I do not feel has been factored in is the danger of interest-rates rising too. This has a particular danger that it will be applied to the larger debt stock. We have seen in recent figures for public finances in both the UK and the US the problem that can be caused by a rising debt stock as this factor influenced the poor figures that both nations have recently published. So far we have not seen the impact of rising interest-rates and if this trend continues it could challenge the credibility of their financial position.

One of the problems of allowing yourself to get into such a position is that it can become self-fulfilling. We saw this earlier this year in the case of Ireland and Greece where worries over economic and fiscal forecasts led to higher government bond yields which made the position even more untenable. A danger for 2011 is that this problem reaches further than just the periphery of the Euro zone and finds bigger targets. If we look at the position of the United States we see a legislature and administration that has decided that relaxing budget targets is the right strategy unfortunately just at the moment that the debt arithmetic may turn against it. Accordingly I feel that the recent tax cut/stimulus programme was and indeed is something of a dangerous gamble. If we move onto a wider scope this is one of the reasons I am not a fan if we take a broad sweep of fiscal stimulus at this time as i fear what may await it down the road.

Perhaps I am not the only person with such fears as after all the US Federal Reserve is spending some US $75 billion per month attempting to depress longer-term yields by buying US government debt. Unfortunately I fear that such a policy has a limit as it in itself undermines the credibility of the financial system where fears are often intangible and subjective.

The position for 2011

As you can see from this article I am concerned about the possible impact of higher longer-term interest-rates in 2011. The picture for shorter-term or official ones is quite different if we exclude China and India. One of the ways I feel that I can best express this si that to explain my whole career since the mid-1980s has been a period of falling longer-term interest-rates in the UK and I wonder how strong this effect has been. If this has been a significant  influence on our economic growth over this period then we have two problems. Firstly the scope for further reductions is limited as the yield on longer date gilts has fallen from 15% to under 3% at it lowest point. Secondly will some of these beneficial effects be reversed if longer-term rates rise?

Introducing a new factor our inflation problem continues, what if investors start to demand a positive rather than a negative real yield? Also one day QE will need an exit strategy, what happens then? We are at the time of year for questions about what will influence us next but I feel that one matter the setting of official interest-rates is less significant than it was for the reasons I have explained today. In my opinion this does not refelect well on those who have contributed to this.

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9 thoughts on “Longer-term interest-rates will determine much of what happens in 2011 in the UK and abroad

  1. Hi Shaun.. I agree with this completely. Rising interest rates not only makes borrowing by businesses more expensive but forces cutbacks in services provided by governments at all levels due to the higher expense of debt service. The US Gov’t is caught between Democrats who want to spend and Republicans who want to cut taxes.. and the path of least resistance is to just keep borrowing at obscene levels so as to avoid the Day of Reckoning. The US will never willingly enter into austerity as did the Irish; it will only (and inevitably) happen at the point of the bond market’s spear.

  2. What makes me nervous about all this is the debt time bomb.

    The UK has borrowings of about £1tn (roughly). Assuming long term interest rates are 4% then this costs us £40bn or about 10% of the UK’s tax receipts. But, if the debt keeps rising at circa £150bn per year, and investors lose confidence we could see in 2 years uk debt of around £1.3tn paying say 5% which equates to a long run rate of £65bn or 16% of the tax take in interest payments alone. In other words, if the govt doesn’t get it’s borrowing under control they could quickly find that they have to make Greece style cuts just to maintain the interest payments!

    Sacremongery? Remember Greece is paying 12%. That would cost us £156bn or 39% of the UK’s tax take! The cuts that would require are probably the cuts we should be making now before we get into that position.

    • The failure to understand this arithmetic (or perhaps the desire to believe in improbable UK growth percentages) is what underlies the present assertions of the left that we should spend more, not less. Cameron needs to explain this matter rather more clearly than he has because people want state jobs and services. They really, really don’t want cuts to our present, debt-fuelled lifestyle; they simply lock on to anyone who tells them cuts are not needed. As has been said here many times, much of the present economic thinking of our leaders is based on ‘kicking the can’ down the road for ever. Naturally that has its limits, unless we really believe we can stimulate genuine, substantial and sustainable growth and recovery of the losses of the past three years, in which case it is right. Growth is crucial, but little discussed.

  3. Hi Shaun, thanks again for all of your posts over the year – always very informative and thought-provoking. On the subject of disintermediation, what was the mistake made in the 1980s? (forgive my ignorance – I was still at primary school!) Was UK M3 used to set interest rates? Also, what are your thoughts about the different measures of money supply in terms of their relevance to future inflation? Am I right in thinking that M2 (i.e. all fairly liquid deposits?) might be a decent forward-looking indicator rather than M3? (to be used in conjunction with price indices and unemployment figures of course) I have been keeping an eye on the ‘shadowstats’ US money supply numbers, but not being an economist, I’m not sure how reliable the numbers are:-

    http://www.shadowstats.com/charts/monetary-base-money-supply

    A new long-term trend of rising interest rates would surely be very bad for economic growth in the West – we are not in the same situation as the last time this happened; after WWII. In contrast to then, we now have an ageing population rather than a baby boom, and are in the wrong part of the ‘commodity supercycle’ (this could be ‘peak easy oil’, in contrast to the post-WWII Middle Eastern oil bonanza).

    I agree with you that over-indebted Western governments should be very worried about rising interest rates further out along the curve, and I wonder how central banks would react in these circumstances. Would they adopt even more QEstionable tactics, or would they stand back and allow government spending to take the strain? Do you think the UK and/or the US are facing an unavoidable default-or-inflate choice, or is there still plenty of room for maneuver?

    Sorry if these are gloomy thoughts – have a Happy New Year (at least you should have plenty to write about for the foreseeable future!)

    • Hi Graeme
      Thanks for asking the question as it reminds me of the fact that people of many ages read this and I should try to be careful not to (subliminally) think that just because I remember some events that they are common knowledge…

      Going back to the period the early Thatcher years had some significant economic changes which meant we needed a new monetary structure. If as ever we leave the politics aside in essence the period after her election saw a liberalisation of our monetary system with for example exchange controls being scrapped. If you add to this the change of Competition and Credit Control changes of the Heath government from 1974 the landscape had changed and of course it was only a few years after us having to call in the IMF in 1976 ( for the old reason of an exchange rate/balance of payments crisis not the new one). So going forwards there was fairly widespread acceptance we needed a change and the Thatcherite dictum was a type of monetarism. There were two choices and one links with your link as it was monetary base control as one alternative and the other was a wider measure which was £m3.

      As ever the fact that monetary base control had seemed to work fairly well in places such as Switzerland did nt carry much weight and we went for £m3 which seemed to have a good relationship with inflation some 18/24 months later. There were some successes from this but also problems. For example interest rates needed to go quite high to get any sort of grip on £m3 and hopefully inflation 18/24 months later and the rises contributed to a recession in the early 1980s. However the problem with £m3 was that it covered some but not all monetary activity and disintermediation crept in where the same economic activity took place as before but was driven outside the £m3 definition. One clear example of this was the fact that building societies were not included ( they are in m4 which is essentially why it is now used). As it happened the influence of the building societies increased partly due to the privatisations of the period so a problem was exacerbated leading to Goodhart’s Law.

      Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes

      One side effect of the use of £m3 was that you could use it as a way of constructing an equation for the monetary system which implied that £m3 and hence hopefully inflation could be reduced by issuing extra gilts which we then did. So this era had a type of anti-QE which was called overfunding. This again had patchy results a lesson which in my view should have been learnt for its doppelganger…

      So what was learnt? Rigid reliance on one monetary measure is a mistake. For the UK we should take more note of the narrower measures was a clear lesson.If you were only to use one measure it is very difficult to choose but some countries appear to have some success with narrower measures whereas wider ones used in the UK have not really worked. The irony is that as we sit now the narrower money measures have been influenced and manipulated so much by central banks that it is hard to know what is genuine economic activity and what is Goodharts law in action.

      As to QE helping going forwards I suspect that its limits may already have been reached but of course I do not know that as QE3,4,5….. would really be steps into the unknown.

  4. Hi Shaun,
    Well done with the Ashes. There was a lot of support for the Prisoners Of Mother England from this side of the Tasman. Your supporters are the best. They were out her in force for the last Lions tour and they left a very good impression on us. I think your Mr Swan will have his day in the sun in Sydney. He did well in the last innings in Adelaide. Will the Barmy Army be able to put something to Disorder to describe the Aussies?
    It will be interesting to see how your boys get on out here in the World cup. I am not sure how the draw is made up but we would enjoy an England v NZ final.
    Our economy is very interesting. We were one of the first to deregulate in the 1980s. For the last ten years we have had an over priced currency which has hit our productive sector. To compensate we as a nation have borrowed a lot of money from overseas and used it to push up house prices and to spend it on consumption. We do not have any savings and we do not have a very good record of investing in the productive sector. One of our main assets are our innovative people however our most innovative live over seas. One fifth of our population ( total of 5m) are off shore. Our economy has gone nowhere since 2007. My view is the longer the recession has gone on the more the average person in the street is starting to realize that we have been living beyond our means for far too long and the party is over. If our $ was to drop by 30% then the chickens will come home to roost in spades. So against this background consumption has slowed down (there is only so much junk one can buy!) people are paying off debt if they can. The velocity of money has taken a hit. House prices have come back by only 5% from the peak in 2007 Inflation is taking hold and interest rats are creeping up. Unemployment is relatively low but does not tell the whole story. We have an aging population, and a very high sickness benefit numbers (which are long term and increasing) and our productivity has gone nowhere for 20 years. Our last administration (God bless their cotton socks) increased our public service by 42% over 9 years. Our government is half of our economy and is very inefficient (the third oldest lie in the world is “I am from the government and I am here to help you”) This was fine while house prices kept going up and we had positive immigration. The music has stopped. One concern I have is that we are very reliant on the carry trade. Mrs Watanabe has a fair chunk invested here. Should she decide to pull the plug then things will get interesting. There is some suggestion that Namoura alone has in excess of NZ$20b invested here. At the moment our exports are getting record prices however this has not lead to growth. We seem to be in a period of stagflation and at the mercy of events overseas. Quiet frankly the international outlook does not fill me with confidence.
    The earthquake has had various consequences. Overall it should bring money into the economy as all our reinsurance was off shore. In the meantime it has caused chaos mainly in Christchurch. It will take some time before the rebuilding gets under way.
    Sorry to ramble on Shaun. I seem to be sounding so negative. I like to think I am a positive person (Mrs Murphy said Mr Murphy was an optimist) I still have a roof over my head and I am getting three meals a day so it cannot be all that bad!

    • Hi Bones
      I have been monitoring events from a distance and NZ are on my mind not for the obvious reason of the 6 nations starting which I won’t mention as I know people who are recording it and think that this is even more likely on the other side of the world. It was because you guys are delaying your election because of the rugby world cup, that provoked a smile anyway. A nice touch and if you will forgive me conforming to a stereotype all in one go!
      I had noticed that your government bond yields had dropped which goes against the international trend. Sadly it doesn’t look like it has dropped for good reasons but more because of a slowdown. I see the unemployment rate has risen to 6.8% and that it is looking more likely than even when you wrote your note that you may have double dipped ( for other readers the NZ economy contracted in the third quarter of 2010 and recent data implies it might have also shrunk in the fourth altho’ the recent UK numbers show that nothing about official statistics is certain). So having started by thinking NZ might be doing okay as I have looked further I see that in fact it is the other way, so I have a question. Why do you think that with your economies performance your bond rates are so high at 5.4/5.5% for your ten-year maturity? Also I would have thought that NZ would be one of the gainers from the rise in food prices.
      As to the cricket our Ashes win was very satisfactory. The Swan song (sorry!) went down very well over here altho’ to be fair the bowler who deserved it was Jimmy Anderson who has worked on his game and become a top quality seamer. In truth according to Sir Geoffrey of Boycott finger spinners rarely do well in Oz….We are doing poorly in the one dayers but the emphasis here was on the Ashes so it is hard for anyone to blame the team for doing the same. As to songs for the Aussies I did hear one time a few years ago a song with the punchline ” and they voted for the Queen” which reminded us that Oz had and went down very well as I don’t think we in the UK ever have.
      I know that there is a lot of competition and rivalry between NZ and OZ in many sports. In the UK we enjoy the Ashes in cricket and it goes down well and as a sport it is hanging on. Indeed we are a place where test cricket is well supported and profitable. The game itself is not always played in schools but is trying to regroup in many areas and it has many enthusiasts inspite of being poorly run at the top. However we are the targets in so many sports. I guess it will teach us to invent them!

  5. I guess the central banks just hope they will have created enough inflation to wipe out the debt overhang before the interest rates rise to create the next recession.

    Long term interest rates can only go up from here as the only way out is inflation,hence why the US is printing lots of money even if it is shipping lots of it to China!

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