Archive for the ‘Interest Rates’ Category

file0001742232424The UK economy grew by 0.7 per cent in the second quarter of 2015, and by 2.6 per cent over the past year. The US economy grew at an annualised pace of 2.3 per cent. The media and markets greeted the figures with relief, but they were wrong.

To understand why, first consider what things were like in the first quarter of this year. The UK grew by 0.4 per cent, that’s quarter on quarter, and the US grew by 0.6 per cent– annualised. Actually, the data for Q2 had been revised upwards, so the markets had a kind of double celebration. They were chuffed by the okay figures for Q2, and even more chuffed by the upwards revision for Q1. Even so, bear in mind that in the latest quarter both the UK and US economies grew at a rate that was still way below average. As for Q1, the data may say that the US grew by 0.6 per cent annualised in Q1, but frankly that is a pretty awful performance. It’s just not as awful as the figures originally suggested. It is like coming last in a race, and then celebrating because the judges discovered they had made a mistake and in fact you only came second from last.

History tells us that economies tend to enjoy a period of above average growth when coming out of recession. History tells us that when an economy suffers a one off shock, which is supposed to have been what happened in Q1 of this year, then the following quarter should expand at a faster than normal pace to make up for the lost production of the previous quarter.

We are told that poor figures on the first quarter were down to a shockingly bad winter in the northeast corner of the US. This even affected US imports to the UK, knocking the UK economy. If that is so, however, shouldn’t the second quarter have seen unusually fast expansion, making up for lost ground?

In the US, the Federal Reserve is losing patience, it will be a big surprise if US interest rates don’t go up very soon, September most likely. Rates will be rising in the UK soon too, probably January.

Once again, consider the lesson of history. The Fed increased rates in 1994, after a period in which they had been at 3 per cent for 18 months or so. A year and a half later, US interest rates were at 6 per cent. Crisis soon followed, however. The global economy had got used to low US interest rates, when they rose capital left developing markets and headed west. We had the Asian crisis of 1997 and the Russian crisis of 1998. The global banking system tottered.

A similar story occurred all over again the following decade. This time though, US rates were cut to 1 per cent, stayed there for about a year, and then gradually began to rise. Within a year or two, come 2008, the global banking system did more than totter, it fell over. We all know how nasty that was.

This time US rates have been at near zero per cent for almost seven years. As they rise, the shockwaves across the world will be nasty.

The problem is compounded. Critics of the Fed say that by cutting interest rate to near zero, it has nothing left to give in the event things make a turn for the worse. The snag with that is that if the Fed hadn’t cut rates so low its economy may have suffered an even more nasty turnaround. It is like a runner in a race, holding back for a sprint finish. But if the race leader sets a fast pace, and our runner goes with the leader and has the sprint run out of him, or indeed her. You can’t criticise the runner for going too fast, there was no choice.

In short, rates are low because they had to be, now they are rising because they have to. Neither the US or UK economy are strong though, indeed they are more like a wheezy athlete, about to start a long uphill climb.

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The Bank of England says a rate hike is not likely until 2016; the markets are pricing in a 2015 hike. But might they rise even sooner than that?

These days it’s about unemployment. The Bank of England now says that for as long unemployment is above 7.0 per cent it won’t be upping rates. It says this is not likely to happen until 2016, that the markets are too optimistic, and that there is just a one in three chance of a rate hike sooner than that.

One of the lessons of the last few years is that when the economy is entering a downturn, economists and markets alike tend to underestimate the speed of contraction. Yet it seems equally clear that when things are improving, markets and economists tend to underestimate the speed of recovery.

The OECD has joined a long list of economic forecasters to revise its projections for UK growth upwards. The latest Purchasing Managers’ Indices (PMIs) from Markit/CIPS point to quarter on quarter growth of between 1 and 1.34 per cent in Q3. In fact, the latest composite PMI tracking construction, services and manufacturing has hit its highest level ever since records began in the late 1990s.

So if the UK economy is expanding so much faster than the wildest optimists forecast just a few months ago, is it not possible that UK unemployment will be back to 7 per cent faster than both the Bank of England and markets are predicting?

Yet more evidence to support this case comes from recent data from the ONS. It has recently begun experiments with month on month data on UK unemployment and recorded a fall from 7.8 to 7.4 per cent in July. A recent survey from the CIPD has its headline index tracking employers’ intentions to hire more staff hitting its highest level since 2008. The PMIs for July pointed to the fastest rate of job creation since 2007. And if we really do see the boom in residential construction that many are predicting, the effect on employment will surely be significant.

There are problems with these rosy forecasts, however.

For one thing, data on month on month changes in the jobs markets are highly volatile – the August data may see July improvement cancelled out. The PMI for August may have pointed to faster growth, but as far as job creation is concerned, it was nowhere near as positive as the July reading.

The big doubt related to what they call the productivity puzzle.

Until recently a characteristic of the UK economy has been disappointing growth in GDP, but surprisingly robust jobs figures given the state of the economy. Of course the mathematics of poor growth but reasonable job creation has meant poor productivity. Lots of theories abound for the poor growth in productivity, with one of the most popular being that employers have been choosing labour which has low upfront costs, over investment into capital equipment. In other words, they prefer staff, who they can always fire, to labour efficient machinery which requires a bit of upfront outlay, and cannot not be easily sold. Is it not possible that as the economy improves, so will productivity, and just as unemployment was relatively low in the recession, it will be relatively high in the recovery? If that is right, then interest rates may stay at half a per cent for some time yet – regardless of whether the recovery exceeds expectations.

© Investment & Business News 2013

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According to a Halifax report, new mortgages are at their cheapest level in 14 years. Mortgages taken out during Q1 accounted for just 27 per cent of borrowers’ net income. In 2007 the ratio was 48 per cent; over the last 30 years the ratio was 36 per cent. Yippee to that.

It is just that…

Remember interest rates are at a record low. They are hardly likely to fall, but they are likely to rise. The Bank of England tries to re-assure us by saying rates are unlikely to go up until 2016. Alas, most new borrowers will not be repaying their mortgage in full between now and 2016. Who knows what rates will be in five years’ time, in ten years’ time or in 20 years’ time? It is anyone’s guess.

Remember that the markets have concluded that rates are rising sooner rather than later. The yield on UK government bonds is now at a two year high. Mortgage costs may rise in their wake.

Above all remember this. Sure, over the last 30 years mortgages on average took a higher proportion of new borrowers’ salary than they do now. But over the last 30 years wage inflation was ever present. Who cares about high borrowing to income ratios when incomes are rising so fast?

It is not like that now. Incomes are no longer rising fast, real incomes are falling. Those who celebrate the low cost of mortgages seem to have forgotten this.

© Investment & Business News 2013

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It is the new way of doing central banking. It is called forward guidance. It means that central bankers are telling us what they are going to do in the future under different circumstances. In one fell swoop they have done away with an industry; an industry called predicting interest rates. It has become a game, and in some cases a business. The media fill their pages with predictions on which way interest rates are going next. Now we know, if the data says one thing, rates will go in a certain direction. Yet here we are, just a few weeks into the era of forward guidance, and already cracks are appearing. As for the markets, rather than becoming more stable and predictable, they have become more nervous than ever.

“I guess I should warn you, if I turn out to be particularly clear, you’ve probably misunderstood what I’ve said,” or so once and somewhat famously said the former Chairman of the US Federal Reserve Alan Greenspan. This was the era when Mr Greenspan was set on a pedestal so high that it is a wonder he didn’t need an oxygen mask and climbing ropes. What the markets really loved was the way in which Mr Greenspan had a veneer of knowing something they didn’t know; of having a plan – a cunning plan if you will – that always worked the way it was supposed to.

The finance crisis of 2008, and the fact that we appeared to miss a meltdown in capitalism by a whisker did leave Mr Greenspan’s reputation a little in tatters. Ben Bernanke, his replacement at the Fed, made a great play of saying what he thought; of letting us in, as it were, on his rationale. At first it didn’t go down well. The markets concluded he didn’t really seem to know what he was doing. It is the tragedy of the modern age. All of us stumble around in the dark most of the time, but we just don’t like to admit to it. And when our leaders admit to it, we think they are weak and uncertain.

These days, however, Ben’s stock is high. It was he, first among the central bankers, who came up with the idea of forward guidance, when he revealed that the Fed would keep pumping money into the economy via QE for as long as unemployment remained high. Now they are all at it. The Bank of England – under the leadership of Mark Carney – is now saying that rates will stay at half a per cent as long as unemployment is over 7 per cent.

It is just that the minutes from the latest Bank of England Monetary Policy Committee (MPC) meeting revealed that one member of the committee – Martin Weale – voted against the policy. It was not so much the idea of forward guidance he was against, it was the perceived timing. He appeared to fear that the 7 per cent target was too loose. Er, or maybe you could say that actually he was against forward guidance, because he wants a policy that one might describe as always flexible.

His dissent is important, because it rather put a question mark over the viability of the policy. You can interpret the Bank of England as saying if the economy does this, we will definitely do that, unless, that is, we change our mind. There are also hints that UK unemployment is set to fall much more rapidly than has been assumed. A survey from the CIPD and the latest Purchasing Managers’ Index both point to positive changes in UK unemployment in the pipeline. See: The UK jobs market boost . This has led to speculation that rates might be rising much sooner than the Bank of England has been suggesting.

It appears that the industry that grew up predicting what the MPC might do next has changed into one predicting what unemployment will do. If nothing else, jobs have become a more important economic indicator – and maybe that is no bad thing; after all common sense suggests it should be the most important indicator.

In the US, recent data has pointed to a sharp improvement in the jobs outlook, with the latest survey suggesting US unemployment is now at its lowest level since October 2007.

So let’s review the situation. The signs, both in the form of hard data and from surveys, point to a labour market that is improving faster than many had dared to hope for. That means monetary policy might be tightened faster than many had feared. The markets are spooked by it all. ‘Better than they dared hope for’ jobs data turned out to be less of a boon than ‘rates rising faster than they had feared’, – at least that is what they are saying at the moment.

But then the markets are fickle and how they react one day can be quite different on another. If you think the markets are making themselves clear, it probably means you “misunderstood what they are saying”.

© Investment & Business News 2013

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If only interest rates were higher; it’s the lament of savers everywhere. Then they could enjoy a nice little income from hard-won savings. Some don’t merely sigh; they grimace; they are angry. They worked hard all their life. They saved hard, putting off holidays, sacrificed transitory pleasures today for security, and slowly built a nest egg. But, thanks to record low interest rates, and that policy straight from the devil’s workshop called quantitative easing, central banks seem to want to punish the prudent and reward the feckless. You can feel their anger, and you may share their anger. It is just that they are wrong. And they are wrong for a simple reason.

Dr Ros Altmann is very clever indeed. Until recently she was director general of SAGA, and is generally thought of as something of a guru; an expert on all things pensions. But she is especially famous for her hugely critical views relating to the Bank of England’s recent monetary policy. Her argument runs likes this: low interest rates penalise savers, they penalise those who are retired, and those who are trying to find a way to fund their retirement. She rarely misses an opportunity to slate the government and its central bank whenever it does anything to advance the course of low interest rates. If the anti-quantitative easing (QE) lobby has a face, it is that of Ms Altmann.

But think about this for a moment. If the economy is growing, if real incomes are rising, and if productivity is getting better all the time, then surely we can afford higher interest rates.

Or consider this. Why do we need savings? Across the global economy savings equal investment – they have to, it is a matter of definition. GDP equals consumption plus investment. Savings equals income minus consumption. Income equals GDP. For the economy as a whole, we need savings to fund investment. If we all try to save more, without a corresponding rise in investment, the result is an immediate fall in GDP.

So we save to fund investment. Does that not mean that in the long run, the reward for savings should be a function of the return on investment?

If our savings fund very low risk investment, that generates very little in the way of returns. Why do we think we should get a higher interest rate?

Consider the economy. It has had a very poor few years. There has been no shortage of money, no shortage of savings, but the money has found its way into bonds, and into mortgages. What money has not done – or at least has not done enough – is find its way into more risky assets.

“QE has hastened the demise of our pensions system,” said Dr Altmann earlier this year. She continued: “As scheme deficits rise, their sponsor company’s money is being forced into the scheme rather than expanding or modernising the company itself – thereby increasing the risk that the company will fail and the scheme will be forced into the PPF, with all members’ pensions reduced.”

She makes a good point. The return on bonds is incredibly low. Pension schemes need to generate a certain proportion of their income from bonds, and since bonds pay out such low yields that means pension schemes need to buy even more bonds to meet regulatory requirements.

The truth is that a good argument could be made to say that savers deserve a higher return on the money if their savings yielded better results, created more wealth. Borrowers could afford to pay higher interest rates if, as a result of their borrowing, they made more profits, and enjoyed higher income.

This connection between savings, investment and the return on savings versus the return on investment gets forgotten, overlooked.

It would be a good thing if interest rates rose, but only if they rose because all of a sudden savings were being used to fund innovation, and as result created more wealth.

This, of course, is why savers need to re-evaluate, and start looking at putting their savings in assets other than low risk, low yielding bonds.

© Investment & Business News 2013

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You may remember the ads – it must have been around 20 years ago. They were for a magazine called ‘Fast Forward’ and for a few months they were on TV all the time – or so it seemed. Jeremy Beadle features in the ads and the jingle went “fast, fast forward, forward forward’ and the tune went like this laa, laa, la, la, la. Okay you may not remember the ads, maybe you have subconsciously blocked them from your memory, but if you do remember them apologies. You may now hear that tune in your head every time you hear the phrase ‘forward guidance’. And so, forward guidance is out and now it appears we have an inkling about how long rates will stay at 0.5 per cent.

The latest inflation report, out yesterday, came with a section talking about forward guidance. The Bank of England says that monetary policy will remain ultra-loose for as long as UK unemployment is greater than 7 per cent.

In forward guidance, if inflation does this, and jobs do that, says the Bank of England we will do as follows.

Accept that it’s forward guidance that may change as we move forward. The 7 per cent unemployment rate does not necessarily represent the end of the line for record low rates; rather it is, as Mark Carney called it, a ‘way station’.

Based on Bank of England predictions, for UK unemployment, it appears the first rate hike will be in late 2015.

Then again, if inflation picks up, and even if unemployment is still quite high, Mr Carney suggested the bank may change policy.

So it is a kind of forward guidance, based on current thinking. Well, Carney is human. He can’t do much more than that, but it does leave you wondering what the fuss is about.

It is tempting to say that forward guidance is little more than PR; a communication tool. But then again, the markets seem to be taking to it like proverbial ducks to water.

It does rather seem that forward guidance means the bank does not need to engage in any more QE. If you see QE as kind of weapon of mass financial destruction, then the threat that you may use it means that it is not necessary to do so.

© Investment & Business News 2013

Phew, that was close. UK inflation was 2.9 per cent in June, which was 0.1 percentage points less than expected and 0.2 percentage points less than feared, and some might say it was a relief.

If inflation had been 3.1 per cent, as some dreaded, then poor old Mark Carney, new in his job, would have been obliged to write a letter to the chancellor.

Even so, 2.9 per cent isn’t very good. In fact it is the highest rate of inflation since April 2012.

So here is the dilemma. The Fed is slowly moving towards tightening monetary policy. If it does this, the pound may come under pressure. The Bank of England has made it clear that it is in no hurry to follow the Fed, but can the UK afford inflation of around 3 per cent, and then for the pound to fall?

Remember, between February 2013 and April 2013 total pay (including bonuses) rose by just 1.3 per cent year on year, which was much less than inflation. If the pound falls, inflation will rise, and real wages will fall even further.

A cheap pound may help the UK’s long awaited export led recovery, but the UK also needs households’ real income to rise.

© Investment & Business News 2013