Tuesday, 1 July 2014

Interest Rate Hike – Easy on the Brakes

The Bank of England threatens to be too heavy on the brakes with higher interest rates and the economic recovery may stall as a result

Tinkering with complex machinery is tricky as changing one thing may have unintended consequences elsewhere.  This also applies to the economy.  The prospect of having to raise interest rates at a time when the economic recovery is still fragile is daunting enough.  Yet, there is a number of moving parts of an economy linked with interest rates which could throw an extra spanner in the works – one concern is that higher interest rates will push up the currency and hurt exporting firms.  This may push central banks to use other monetary policy tools to bide their time.

Complicated piece of machinery

What we refer to as the economy is the accumulation of an incredibly intricate multitude of monetary transactions in which we all are a small part.  In comparison, monetary policy is rather basic relying mainly on the lever of interest rates with extra bells and whistles, such as quantitative easing, added only when needed.  Monetary policy has been exceptionally loose but has still struggled to get the economy moving again.  These expansive polices cannot stay in place for ever and there are growing calls for interest rates to be raised off record lows. 

Interest rates normally affect the economy through the costs involved with taking out a loan.  But this is not the only route of influence.  One example is how higher interest rates will attract in money due to a higher pay-out for savings and this extra cash coming into the economy will push up the value of the currency.  A strengthening currency will adversely affect firms exporting to other countries as prices for their goods typically must rise and this risks putting them at a disadvantage relative to competitors. 

The potential for this is larger when one country moves to tighten its monetary ahead of its peers.  Such is the predicament facing the UK as the Bank of England contemplates the possibility of raising interest rates sometime in the next six to twelve months.  The mere expectation of this has propelled the pound higher relative to other currencies and may put further upward pressure on the pound if interest rates are predicted to rise faster than elsewhere. 

This problem comes about due to the freedom of money to chase around the globe after the best return.  Financial firms have made of most of moving cash around using strategies such as the carry trade – borrowing in a currency with a low interest rate and changing the money into a currency where the interest rates is higher.  This is just one way of how excess liquidity in global markets can work to distort exchange rates relative to the actual physical economy.

Warning lights flashing

Normally higher interest rates are used to slow an overheating economy and a stronger currency would help with this.  Yet, the upcoming hikes to interest rates have the goal of returning monetary policy to normality – a state where interest rates and the rate of growth in the economy are roughly equal.  An accompanying rise in exchange rates therefore acts as a further obstacle to economic recovery which is not intended or desirable. 

The weak recovery means that the UK economy is not quite ready for the double whammy of higher interest rates and a stronger pound.  The effects of both may be benign considering the lower rates of borrowing among businesses and sluggish demand for exports from markets such as Europe.  But there is still the potential for a rise in interest rates to put the economy in reverse at a time when the economy is gearing up for recovery. 

The main issue behind calls for tighter monetary policy is a buoyant housing market.  Yet, the Bank of England has a new range of tools to deal with this such as caps on mortgage lending.  So there is room to wait for other countries, most significantly the US, to catch up in terms of interest rates.  With the threat of waiting too long to act mitigated by housing market measures, it is the downside of braking too soon that the Bank of England should watch out for.

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