Monday, May 12, 2008

Forecast for Long Term Interest rates.

In 1991, UK interest rates were 12%. In one crazy week, October, 1992, the government increased interest rates to 15% in a desperate bid to remain in the ERM. Since then interest rates have fallen. Many homeowners have bought houses on the assumption that these kind of interest rates are a thing of the past. If UK or US interest rates returned to these kinds of levels, it would bring real misery to many homeowners. What are the chances for these kind of interest rates to return?

Why Long Term interest rates are likely to Remain Low.

Core Inflation is low.

In 1992, a run away economy caused inflation to reach 10.9%. It was this inflation which cause interest rates to rise. However, core inflation is much lower. At the moment, the MPC are worried about rising inflation (caused by cost push factors) However, CPI inflation is sill close to the 3% upper limit. There was a time when 3% inflation would have been a remarkable achievement. It shows how the goal posts have shifted; people have lower inflation expectations.

Independent Monetary Policy.

There was a time when the government ran monetary policy. There was a temptation for the government to cut interest rates before an election to increase demand and garner popularity with the electorate. This led to boom and bust economic cycles; periods of high inflation and high interest rates followed by recession. Arguably the MPC have done a much better job and seem to avoided these volatile swings in the economic cycle. By maintaining low inflationary growth it has enabled interest to remain permanently low.

Low Inflation expectations.

When inflation is high people expect inflation to be higher next year; firms pass on cost increases; workers demand wage increases. Thus the inflation expectations become self fulfilling. Because inflation expectations are currently low, inflation is unlikely to become a problem in the medium term.

Global inflation is low.

Helped by improved technology and low wage economies like China, global inflation has been lower in the past decade. The UK and US have benefited from this global reduction in inflation.

Why Long Term Interest rates may rise. - Is Inflation really Dead?

Having said all that, there are arguments to suggest that it is too early to talk about the 'death of inflation'. Arguably there is no reason why inflation and higher interest rates couldn't make a return. Some factors include:

Rising Economic Growth

Rising Economic Growth is putting strain on Commodity prices. Already we are seeing rising price of commodities, oil and food. This is due to demand rising faster than supply. As China and India continue to expand at breakneck pace, this problem is likely to exacerbate. This cost push inflation may start to feed through into higher inflation expectations and we could see a resurgence in global inflation.

Chinese / Global inflation is rising.

Ominously Inflation in China has increased to 8%. The era of permanently low priced Chinese good may be at and end. As the economy grows and supply constraints rise, workers will demand rising wages.


In the medium term, I expect inflation and interest rates to remain relatively low. The most beneficial development is the improvement in the trade cycle and the reduction in the boom and bust aspect.

In the longer term it becomes harder to predict cost push inflation factors. It remains to be seen whether supply can keep up with rising global demand. If supply doesn't then it becomes harder to keep inflation low.

1 comment:

Anonymous said...

Congratulation for your blog.

Lately head of BoE's statements seemed to show a completely different than expected future trend for inflation and therefore interest rate.

Could you update your analysis on this basis?