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…
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.