ANATOLE KALETSKY: The only way is up for interest rates and inflation

The only way is up for interest rates and inflation
ANATOLE KALETSKY
business.timesonline.co.uk

MIGHTY rivers begin from the tiny trickle of a single source. In this spirit, we can identify the minuscule quarter-point increase in interest rates announced yesterday evening by the US Federal Reserve Board as the start of a new economic era and the end of a trend that has lasted a generation, dominating global finance and economics for the past 23 years.

Starting in June 1981, when the US interest rates fell from a 20th-century high 19 per cent, each successive cyclical peak in interest rates was lower than one before, as was each cyclical trough.

This declining trend in interest rates has continued through three recessions and two economic expansions, through stock market crashes and bubbles, through property booms and busts. But yesterday, this 23-year sequence of declining highs and lows came to an end.

The Fed’s decision to increase its rate to 1.25 per cent marked the symbolic start of a new era, since the chances that interest rates will fall back to 1 per cent rates or below must be very small.

And this change in trend is not just a symbolic or theoretical matter. Its impact will be felt across the world. The global financial markets are more integrated than ever and even for British businesses and borrowers the imminent change in US financial conditions could be more significant than any decision that the Bank of England takes. US monetary policy still largely determines global inflation and liquidity conditions, has a major influence on currency valuations, stock market and oil prices, as well as setting the psychological background for the decisions of the Bank of England and the European Central Bank.

Its most important effects will be to focus attention on disconcerting issues which finance ministers, central bankers and investors have recently done their best to downplay or ignore: the likelihood of much higher interest rates in the near future; and the deteriorating outlook for global inflation in the long term.

Now that the Fed has started raising interest rates, investors will have to acknowledge that this upward trend has a long way to go. Given that the powerful surge of growth in the American economy after the Iraq war has ended and inflation’s slow but steady increase in the past few months, it is clear with the benefit of hindsight that US interest rates should never have fallen as low as they did. And having cut interest rates to 1 per cent last June — at a time when the economy was already booming — the Fed should have raised them much faster than it did. But what is even clearer is that US interest rates are now far below the appropriate level for this stage of the economic cycle and will need to rise much farther and faster than financial markets currently assume.

In Britain, the Bank of England assumes that interest rates will have to rise to 5 per cent to get to a neutral level, which neither stimulates nor restrains the economy. If so, then US rates will have to rise well above 5 per cent before they start to rein-in growth and inflation. American consumers are less indebted than their British counterparts, US house prices are lower and the US economy has a higher rate of population growth — all of which implies that America should be less sensitive to rising interest rates than Britain and that controlling the economy should require higher rates.

At present the American markets are expecting only a modest increase in rates — from 1 per cent yesterday to 2.25 per cent by the end of the year and around 3.5 per cent in mid-2005. If interest rates next year rise instead to be 5 per cent or higher, investors, politicians and central bankers will be in for some shocks.

The exceptionally low US rates of the past two years have contributed to the extreme weakness of the dollar and the unwelcome strength of the euro and the pound. They have also encouraged a tremendous amount of debt-financed speculation. Investors have borrowed dollars to invest in anything from euros and yen to rand and shares in China and Brazilian bonds.

As interest rates rise, these leveraged speculations will be unwound, with potentially disruptive effects on many economies and financial markets. More fundamentally, the low level of US interest rates has aggravated the biggest long-term danger facing the world economy: a revival of inflation. In fact, the combination of an ultra-lax monetary policy with a rapidly falling dollar has created a situation which is more and more reminiscent of the great inflation which started with the US Government pursuing an expansionary Keynesian guns-and-butter and easy money policy in the mid-1960s, as the Vietnam War gathered pace.

In America today there are seven separate trends all pointing to higher prices and excess leverage in ominous ways reminiscent of the 1960s: first and foremost, a lax monetary policy, with a central bank dedicated to creating jobs, rather than stabilising prices; second, ballooning budget deficits; third, a falling currency; fourth, a hugely expensive war, financed by printing money; fifth, protectionism; sixth, a soaring oil price; seventh, a spendthrift President, who may be a right-wing Republican, but is spending money like a left-wing Democrat. In normal times, any one of these “seven deadly sins” might be sufficient to push up inflation. All seven operating together would be a sure-fire recipe for prices to take off.

This does not mean that the US will return to the rapid inflation of the 1970s and 1980s — 10 per cent or even 5 per cent inflation is unlikely, partly because markets and central bankers have not completely forgotten the lessons of the 1960s and 1970s, but mainly because there is so much more competition and global trade. But even a modest increase — say from 2 per cent inflation to 3 or 4 per cent — would have a major impact on the world economy.

For a start it would damage the credibility of the Fed, and by association, of other central banks around the word. Under Alan Greenspan, the Fed has become the most powerful and respected financial institution of all time. But this reputation will suffer as investors and politicians realise that they have been misled by it. Only four months ago Mr Greenspan declared in his annual report to Congress that the Fed expected US inflation this year to average between 1 and 1.25 per cent and that the risks to this forecast were mostly in a downward direction. Instead, inflation is now running at 2.5 per cent, with higher figures probably ahead. The Fed should be quickly raising interest rates to at least the neutral level of 5 per cent. Yet all indications are that Mr Greenspan will tighten only gently, at least until after the November presidential election is out of the way. Mr Greenspan will soon stand accused not only of misjudging the inflation outlook, but also of delaying remedial treatment to protect President Bush.

Moreover, the cyclical pressures for rising inflation will soon be aggravated by an even more powerful long-term trend: the growing demand for social spending. In the coming decades huge additional demands for non-productive expenditures will be imposed on the US and global economies. While the war against terrorism is the obvious one which attracts the most attention (just as the Vietnam War did in the 1960s and 1970s), the far more important pressures will come in the long-term from demographic ageing and the growing power of the grey lobby to demand public financing of unfounded pensions and healthcare. This is in many ways analogous to the growth of the welfare state and the Great Society in the 1960s. The ever-growing demands of ageing populations will impose a greater burden on the US economy, as well as the economies of Europe and Japan, than any previous social programme or war.

If history is any guide, politicians and voters will decide that inflation is the only way to spread the burden of these ever-growing social costs. If so, then the trend of interest rates and inflation will continue to point upwards for years, or even decades, to come.