Tag Archives: Inflation

When Will Interest Rates Rise?

The Bank of England in Threadneedle Street, Lo...

Image via Wikipedia

With the Bank of England having revised the growth rate down to 2.7% this year (from a previous forecast of 2.9%) and inflation rate up to peak at 5% in the fourth quarter (previously 4.5%), expectations are again growing for an interest rate rise in the near-term.

Of course, the classic economic theory is that a rise in interest rates reduces inflation as spend decreases and so demand-driven price rises are no longer a factor.

However, we’re not living in classical times. This economic slowdown – it can’t be called a recession as we’ve not had a further 2 quarters of negative growth – is persisting and there’s no real expectation of a marked change to lacklustre growth rates throughout the developed world. So it’s not demand that’s driving inflation but rather a number of external forces, including climatic conditions and wars, that have pushed up commodity prices. These won’t respond to a rise in interest rates.

So, given this, let’s understand who benefits from the current scenario and what this means for interest rates.

The main beneficiaries of the sustained low bank rate are:

  • The banks themselves – don’t confuse low bank rates with low interest rates for borrowing money. Certainly, the rates are lower than they were before the crash, but not as low as they should be, given the drop in the bank rate. In fact, looking at interest rates charged to companies and individuals for borrowings, the bank’s margins are extremely high. A margin of 3% to 3.5% (the difference between bank rate and lending rate) is normal – today it’s running somewhere between 5% and 7%, depending on your financial profile. The banks are, quite literally, “coining it” – just look at the new bonus rounds for evidence of this.
  • The government – the massive government debt attracts interest costs (they have to borrow the money). Historically, governments borrow money at, or extremely close to, the bank rate, so by keeping this low, the government reduces the amount of its budget spent on interest to service its massive debts.

Yes, homeowners can benefit to a degree, too – but the advantages tend to be a lot smaller in real terms for most people due to the structure of mortgages and the costs associated with moving between fixed and tracker rates, together with the fact that many people can’t change to take advantage of lower rates due to not having enough equity in their properties following the decline in values. And don’t forget that homeowners repaid a record additional £24 Billion on their mortgages last year – getting their mortgage values down ahead of any possible rise to cushion the impact.

So who benefits from higher inflation?

  • In a word: government. It comes back to the massive government debts that have been rung up in the past 10 years. One way to reduce the effective value of them is to allow moderate inflation into the system – simplistically, 5% inflation over 5 years reduces the effective size of the debt by 25%. Couple this with the increased tax receipts that come with inflation and you have a model to get government debt down much more quickly than would otherwise be the case.

So, given that inflation won’t respond to a rise in interest rates as this is not caused by high demand, and that the government and banks are the primary beneficiaries of having a slightly higher inflation rate and a sustained low bank rate, is it likely we’ll see an interest rate rise soon?

I think not – although I suspect the impact of a rise in bank rates may be felt less than generally expected. In fact, it might well lead to lending rates not going up at all as the banks would use this as a way to try to woo customers from each other, keeping lending rates where they were before – let’s face it, they have more than enough room in their margins to absorb a few modest rises in the bank rate.

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Get used to high inflation!

Assorted international currency notes.
Image via Wikipedia

There’s something missing from all the talk of whether or not the economic bailouts have saved the world from a depression – as opposed to a severe recession – and that’s how the massive spending by governments around the world is going to be paid for.

Perhaps it’s the “party effect.” After all, when you’re having fun at a party, nobody wants to think about the hangover that will be with you tomorrow. Not that we’re all having fun in the current recession, of course, although it could have been a lot worse. But the hangover is sure to follow.

The problem is that governments around the world have realised they are easily able to spend money they don’t have, and the recourse – if it comes at all – will come on somebody else’s watch: generally the opposition party that comes in after them. It’s nice to have your political foe lumbered with your mess…

However, the facts are clear – public debt (i.e. what governments owe) has grown at an alarming rate. Let’s look at a few examples among the world’s larger economies, showing public debt as a percentage of GDP for each country at the end of 2009 (using estimates from the CIA World Fact Book):

  • USA                       83.4%
  • Japan                    192.1%
  • Germany              77.2%
  • France                  79.7%
  • UK                         68.5%
  • Italy                      115.2%

What these huge percentages mean is that, firstly, government is over-spending dramatically and secondly, that the percentage of government income (read: taxes!) that go just on interest payments on this debt has grown to become one of the largest single budgetary items.

In fact, the International Monetary Fund (IMF) recently estimated that Japan and the UK would need to reduce government spending by 13% and the US by nearly 9% just to “restore stability” over the next decade. How can they do this with such massive bills to pay? Oh, and it’s worth noting that the public debt does NOT include provisions for future expenditure on pensions, medical assistance and other state commitments – this is only the current debt!

So, what can governments do?

Reducing government spending to any meaningful degree is often seen as political suicide – especially as elections get closer.

Raising taxes is even worse…

There are only two, linked, things they can do to get the public debt as a percentage of GDP down in a reasonable time: keep interest rates artificially low to reduce interest payments and allow inflation into the system to increase GDP and their own revenue as a result.

A 10% inflation rate over five years will reduce the percentage of public debt by close to half, assuming the GDP growth matches or exceeds the inflation rate (e.g. grows in real terms). The other benefit of this is that government revenues will increase accordingly – higher sales means more sales tax/VAT, salaries rising around inflation rate will mean more tax income (the tax decreases are always lower than the extra amount paid through “bracket creep”), and so on.

My guess is governments won’t allow 10% as it’s psychologically too high, but I expect to see inflation moving quite quickly to the high single-digit range, say, 9%. We’ll need to tighten our belts and adjust our business plans accordingly – the ride for the next decade will be somewhat rough.

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