Friday, 8 August 2014

Interest Rate Hike – not expecting the worst

People tend to fear the worst but higher interest rates may not mean interest rates that are actually that high

Some things that people normally dread as not so bad in reality – such may be the outcome with the upcoming hikes in interest rates.  Interest rates are set to levels which relate to the strength of the underlying economy (as reflected in the level of inflation).  But the pressure to push up interest rates is likely to be limited considering that the long-term prospects for the economy are a bit grim.  On top of this, there is a growing range of policy tools that central banks can use instead of interest rates to manage the economy.  So when higher interest rates do come, like a visit from the in-laws, it may not be as painful as had been expected.

Inflation not so scary

One of the main jobs of central banks is to set interest rates so as to keep inflation low.  This is because inflation in itself is seen as having a negative influence as well as being a sign that an economy might be overheating.  Inflation comes about as firms increase prices typically when their costs are rising or when demand is strong.  Yet, neither is the case at the moment.  Stagnating wages, which is the largest expense for many firms, mean that higher costs are not likely to translate into higher prices. Sluggish consumer spending is prompting some firms to cut prices so as not to lose customers.

This is more than just the result of a sluggish economic recovery as shown by growing concerns about the long-term prospects for the economy.  Investment by businesses continues to remain weak despite record low interest rates.  The expanding operations of companies would help to fuel gains in productivity which further feed into higher wages.  But, with firms not wanting to spend and consumers not likely to get their hands on much extra cash, economic activity is expected to remain subdued.  Austerity measures are a further damper on the economy as governments rush to sort out their finances.

The most glaring reason to not expect any trouble from inflation is prices have barely budged despite everything that has happened over the past decade.  Inflation has remained subdued (mostly 5% or (much) lower) despite a surge in bank lending in the lead up to the crisis or central banks printing billions in new cash in more recent times.  The only time inflation popped up on the radar of policy makers during the depth of economic recession in 2011 due to high commodity prices (more on that later).

This time is different

Not only is inflation expected to remain low but influences over monetary policy are also likely to act to keep interest rates low.  For starters, the potential for a slower pace of economic growth will make it difficult to justify central banks raising interest rates.  Calls for a hike to interest rates at the Bank of England (which is likely to go first among the larger central banks) may be premature considering low inflation and the stuttering economic recovery. 

Monetary policy is also developing so that central banks have more options available to them to deal with inflation and other negative aspects of a buoyant economy.  The most promising of these are macroprudential measures such as caps on mortgage lending and other controls on banks.  These will enable central banks to rein in overheating parts of the economy without having to increase interest rates.

There have also been changes to inflation itself.  As mentioned above, any inflation recently has tended to come from outside sources such as commodity prices rising in global markets in line with growing demand in emerging markets.  Higher interest rates can only have an effect when a rise in prices is due to factors within the economy itself.  So if inflation is due to external causes, central banks will likely hold off increasing interest rates.

Hope for the best

So, there is likely to be no rush to increase interest rates, and when the inevitable does happen, interest rates are not actually going to rise by that much.  This is welcome news for places where buoyant property prices have push new home owners to take on large mortgages relative to their income.  Higher interest rates still have the potential to stall an economic recovery that is still fragile.  But if central banks wait for the right timing, the eventual interest rate hikes may be like going to the dentist expecting to have some teeth pulled but instead just getting a clean and a lollipop.  

Wednesday, 6 August 2014

Economic Recovery - Downgraded

Amid talk of economic recovery, we may not get back to living the life we had in the past

Being downgrading can be tough – no one likes having to get by with less – but this is what we might have to put up with regard to the economy.  Life was much easier around a decade ago when we were enjoying the perks of strong and steady economic growth.  But the upgrade was likely temporary when considering that it was funded with a borrowing binge that was unsustainable.  With wages likely to continue to stagnate for years to come, we may not have it so good again for a long time.

Anything but first class

Gains in wages are typically the main route to the good life for most of us.  Bigger pay packets at the each of the month give us more money to spend.  This money goes back into the economy to create a virtuous cycle helping create a healthy economy so that wages to rise again in the future.  The main avenue through which wages rise is higher output per worker.  This involves people being put to more productive use whether through raising their levels of skills, working together with machines or computers, or doing business in a better way.  The economy usually operates to ensure that this happens automatically as businesses, which want to maximized their profits, will try and make the most of their staff. 

Yet, the past few years, if not the past few decades, have shown us that the tendency for higher wages is not something that we can take for granted.  This is because the two forces of globalization and technology have made life tougher for many people in richer countries.  The sectors of the economy which typically supported the middle class with stable and steady jobs have been eroded.  Jobs such as those in manufacturing along with clerical work have been either moved to countries where labour is cheap or increasingly carried out by machines or computers. 

This has led to a polarization of the work force between high and low skilled areas with a shrinking middle ground.  At one end of the spectrum are bankers, IT experts, and professionals whose knowledge and training ensure a high level of pay.  The rest of the workforce is left with menial jobs such as taxi drivers, shop assistants, and delivery personal only because these are jobs that can’t be shipped overseas.  On top of this, austerity measures in many countries also mean that public sector workers are also suffering.

No route out

With many of us now competing with machines or overseas workers, our bargaining has been considerably diminished.  So while wages rises is a perk that many are missing out on, profits for many businesses have never been higher.  Profitable firms could be the agents of economic growth by expanding their operations and investing in more equipment.  Yet, with weak wages crimping consumer spending, most companies prefer to hoard their cash until the economic recovery is more robust.   What seems like a common sense strategy for each firm has added up to a prolonged slump for the economy as a whole.

The government could step into the breach and provide the investment in worker training or infrastructure to boost productivity.  Yet, the infiltration of pro-market economic theory has pushed the government to the sidelines of the economy.  Even the wealth that had been created in the boom years before the crisis was only benefiting a small portion of the economy.  One example is the finance sector that was creating wealth that mostly went to those working in finance rather to the economy as a whole.  Building a road or new schools creates benefits now and in the future while repackaging of loans only generates money for a lucky few working in banking.

Stuck with a second class economy

Workers have been battling with the consequences of globalization and technology for decades but could rely on debt in the past to enjoy some of the high life.  But like an ever expanding credit card balance, this spending spree was never built to last.  To make things worse, even politicians got involved.  The US government with Bush junior in charge slashed tax rates while the Labour government spent lavishly on the UK public sector around the turn of the century. 

Government finances had been boosted by economic growth fuelled by debt but this was a luxury that would prove fleeting.  Now government is like the rest of us in having to cut back.  Without many goodies going around, voters are likely to become increasing tetchy.  Politics is also getting ugly with constructive policy making likely to go out the window.  Low interest rates and more debt have been offered up as a way out but this creates even more problems in the absence of economic growth.

Something special will be needed to get both consumers and businesses to hope for something better.  Yet, the grim realities of life mean that this may not happen anything soon.  Like being in a long haul flight in economy class, we might be stuck here for a while.