By: Tim Bennett
08.11.2017
08.11.2017
In the wake of the Bank of England’s recent rate rise, Tim Bennett looks at the three key factors that will determine where global interest rates go from here.
Is the low interest rate era coming to an end?
The US Federal Reserve has already started down the path of interest rate rises and is embarking on a reversal of previous monetary stimulus (being called “Quantitative Tightening”). Meanwhile, the Bank of England recently raised interest rates to reverse its previous post-Brexit vote cut. A key question for investors is therefore, what next? Is the low interest rate era drawing to a close or is this selective tightening amongst some Central Banks a policy blip? The answer depends on what truly drives interest rates and here opinion is split.
The three horsemen
Economists are divided on what really lies behind global real rates of interest, which have been largely in decline for several decades. Three factors are thought to be in play as the following slide shows;
Let’s take a quick look at each as the future direction of interest rate policy depends heavily on the weight ascribed to each. Please note that what follows is a mere snapshot of a huge volume of economics!
1. The end of the savings super-cycle
This argument has been cited recently by a number of key commentators, including the Bank for International Settlements. It runs roughly as follows.
In developed-world economies a bulging section of the workforce has been busy saving for retirement over the past few decades just as China, in particular, has added a huge new pool of savers to global markets. Throw in a growing number of technology companies globally, which tend to have much lower demands for capital than more traditional firms, and the result is a world awash with savings. Low rates are an inevitable consequence.
However, times are now changing. As developed world savers retire they will start to spend. Meanwhile, previously thrifty emerging market savers are starting to do the same. As a result, interest rates will have to rise globally, whether Central Banks like it or not.
In developed-world economies a bulging section of the workforce has been busy saving for retirement over the past few decades just as China, in particular, has added a huge new pool of savers to global markets. Throw in a growing number of technology companies globally, which tend to have much lower demands for capital than more traditional firms, and the result is a world awash with savings. Low rates are an inevitable consequence.
However, times are now changing. As developed world savers retire they will start to spend. Meanwhile, previously thrifty emerging market savers are starting to do the same. As a result, interest rates will have to rise globally, whether Central Banks like it or not.
2. Traditional economic models are not working
Some observers are increasingly worried that Central Banks are potentially compounding this issue by effectively watching the wrong signals when setting interest rate policy. In particular, their over-reliance on traditional data when setting rates may no longer be wise given the way the global economy has changed.
In short, the key relationships on which they rely, such as that between the inflation and jobless rates (the Phillips Curve) may no longer hold true the way they used to in a global, high technology world. Traditional labour is now freer to move at will and unions have little power over wage rates, meanwhile large numbers of conventional roles are being usurped by automation.
All this suggests that short-term inflation and jobless data may have parted company meaning that the assumptions used by Central Banks to read inflation data and set interest rates may be defunct. The result? We may be storing up an inflationary shock if short-term interest rates have been held too low for too long.
In short, the key relationships on which they rely, such as that between the inflation and jobless rates (the Phillips Curve) may no longer hold true the way they used to in a global, high technology world. Traditional labour is now freer to move at will and unions have little power over wage rates, meanwhile large numbers of conventional roles are being usurped by automation.
All this suggests that short-term inflation and jobless data may have parted company meaning that the assumptions used by Central Banks to read inflation data and set interest rates may be defunct. The result? We may be storing up an inflationary shock if short-term interest rates have been held too low for too long.
3. Central Banks may not be able to reverse QE smoothly
The Federal Reserve is setting off into uncharted territory as it starts to reverse years of money printing (“Quantitative Easing”). Whilst it hopes to achieve this reversal and shrink its balance sheet smoothly, there is always the possibility that bond markets throw a tantrum. After all, what if institutions have been driving bond yields artificially low by buying bonds and hoarding them fearful that the supply would be diminished by QE and now start dumping them en masse as the reverse policy kicks in? Could we see QT grind to a sudden halt and even morph back into QE if asset prices start falling and growth stalls?
Conclusion
No-one has a crystal ball on interest rates. Where we go next will very much depend on how these three key factors interplay over the coming months and years. One thing is for sure – all three will keep many a Central Banker awake at night for some time to come. For investors, the key will be to keep a watchful eye on inflation data but also ensure that portfolios contain at least some element of protection.
