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    Here we go again: worried customers outside a US bank during the financial crisis of September 1936

    Here we go again: worried customers outside a US bank during the financial crisis of September 1936

    Interest rates must rise, but when?

    14 November 2015

    The direction of travel for interest rates appears clear. Both the US and UK economies are growing at roughly their annual trend rates of around two per cent — and our interest rates need to rise to return to more normal monetary conditions.

    Most economists have told pollsters that they expect this to happen. In the UK, normality would mean interest rates moving back eventually towards three or four per cent. One reason why a rise is necessary is that central banks need to be able to cut interest rates again when there is another deflationary shock. Starting at the present zero-rate boundary would make such monetary stimulus impossible. That means we should start to raise them now.

    Higher interest rates will help savers, who will begin to get a return on their cash. There will be a shake-out in bond markets as higher rates depress the price of bonds in secondary markets. Initially, equity markets are likely to benefit from the clarity of knowing what is happening. Companies with strong balance sheets will be better placed, whereas large multinationals overburdened with debt will be vulnerable. As bond yields rise, equity sectors that have high-yielding ‘bond characteristics’ — such as utility companies, — will become less attractive in terms of relative yield.

    There is also something of a healthy de-synchronisation taking place. The slowdown in China and the struggling recovery of European economies coincides with the Anglo-Saxon economies expanding at a reasonable pace. This may avert a future coincident international cycle in which many economies overheat at the same time and then deflate together, aggravating the overall problems of the economic cycle.

    In the script so far, rates go up before the end of this year and rise gently throughout 2016. The question, in that case, is: will the incremental rate rises be smaller than the normal quarter-point movement, and what psychological impact will they have on equity markets?

    Yet there is also another script being drafted by the financial markets. In this alternative plot, the central banks, and the US Federal Reserve in particular, are much more cautious. To understand why, we have to dip back into history to 2008. This was the year when capitalism suffered a cardiac arrest, equivalent to the shock that propelled the world into the Great Depression of the 1930s. To avoid turning a deep recession into a depression, central banks tore up the rulebook and abandoned previous policy homilies. Away went the neat division between monetary and fiscal policy. The maxim from the time of Walter Bagehot that a central bank should be a lender of last resort to illiquid but solvent banks was abandoned. Illiquid banks were assisted and insolvent bankrupt banks were rescued.

    Central banks, led by the Fed, devised new methods of conducting monetary policy. The main innovation involved buying huge amounts of government and other debt held by banks: quantitative easing. Where it was intended to lower long-term interest rates to help investment and the housing market, it was called ‘credit easing’.

    £800bn
    Size of US Federal Reserve’s balance sheet in 2008
    £4tn+
    Size of US Federal Reserve’s balance sheet now

    As well as QE, the Fed developed a communication strategy as a sophisticated tool of policy. Central banks, particularly when they are in trouble, have always engaged in ‘open mouth operations’, but the Fed took this to a new level. Since the crisis, it has used its communications to make it clear to bankers and everyone else that interest rates were going to stay low for a long time. The Bank of England mimicked the strategy in a clumsy manner that was partly undone by a forecast for unemployment that turned out to be too pessimistic.

    It was not an accident that the Fed took the lead in developing these innovations. Dr Ben Bernanke, its chairman until 2014, is a Great Depression buff in the way that other American academics are Civil War buffs. Bernanke understood that in the 1930s the Fed had turned a bad shock into the Great Depression by contracting the money supply by a third and failing to save a banking system that suffered 5,000 bank failures between 1930 and 1933.

    Bernanke promised that the Fed would never make the same mistakes again. Since 2008, its balance sheet has ballooned from around $800 billion to more than $4 trillion. Instead of a third of the banking system being allowed to go under, and with it the credit system of the American economy, the banks were saved. If banks’ ‘toxic’ assets were under water, the Fed bought them up. Instead of national income falling by a third as it did in the Great Depression, during the Great Recession in America it fell by just five percentage points.

    As well as recognising the need for a prompt and effective monetary response to an adverse shock, the Fed knew it must avoid the mistake of removing monetary life support too early. In 1936, in what is considered by historians such as Bernanke to have been the Fed’s second big mistake, it tightened policy, creating a second leg to the Great Depression. That mistake is embedded in the institutional folk memory of the Federal Reserve.

    The big question in modern US and British monetary policy is how to get back to normality. How does a central bank begin to deflate a balance sheet that has ballooned to the equivalent of a quarter of a year’s national income, and start raising interest rates for the first time in years? The challenge is to do it without scaring financial markets — and without taking too much cash out of the system in one go. The threat to the prices of financial assets from the eventual rise in rates may come more from the psychological shock that the moment has finally arrived than from the actual impact of the change in interest costs.

    But still, the need to do it is plain. Prices of bonds and equities have been inflated. The world economy, as the Bank for International Settlements worries, is awash with liquidity that has a habit of amplifying economic cycles. Credit markets are distorted. Big corporations can borrow cheaply in bond markets, while small companies dependent on bank finance struggle for cash. Low interest rates generate a form of financial repression that encourages inappropriate risk-taking by savers and investors.

    Yet Janet Yellen and her colleagues remember 1936. The markets sense that caution is her middle name; inflation remains low, and she does not want to be the inspiration for graduate students to writing theses titled Dr Yellen’s Big Mistake: Forgetting 1936. The markets are betting that for some time yet there will always be a worry about China, or a bad set of non-farm payroll figures, or the judgment that a change in the relative value of the dollar represents an effective tightening, that will hold the Federal Reserve back. The rate rise we need may not be coming any time soon, and when policy starts to tighten its pace will probably be timid. We had better start calculating the consequences of that delay.