Sunday, February 10, 2008
Setting the course for a neutral rate
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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We know, thanks to the Bank of England’s decision on Thursday, where interest rates are in the short term. But where are they heading in the next few months? And will we look back on this period as a time of unusually low or high rates, or something close to the norm?

It is a big question. The days when the nine members of the monetary policy committee could happily slash interest rates in response to international events such as the 9/11 attacks on America or the Iraq war appear to be over.

Last week’s decision to cut Bank rate from 5.5% to 5.25%, and the statement that accompanied it, epitomised the “difficult balancing act” Mervyn King has warned about. On one side there is the risk that a short-term rise in inflation will become ingrained in inflationary expectations and pay. On the other was the risk that a “sharp slowing in activity pulls inflation below the target in the medium term”.

The governor still looks forward to the “calmer waters” of low inflation and a better-balanced economy. No doubt he is at this moment thinking of a colourful analogy to present alongside this week’s inflation report.

Some talk about the Bank’s problems being tantamount to stagflation; stagnation combined with high inflation. As somebody who does remember the 1970s, and paraphrasing a famous American political riposte: I knew stagflation; this is no stagflation.

So where is Bank rate likely to settle? When it rose to 5.75% last summer, there was plenty of talk of it climbing to 6%, 7% or even 8%. Some of the same people who were predicting those rises are now forecasting falls to 4%.

There is, however, something like an invisible elastic that pulls the rate back towards its norm whenever it threatens to move too far away from it.

When the Bank was granted independence, nearly 11 years ago, its initial task was to establish its antiinflation credibility. Bank rate, 6% on the day of the independence announcement, was raised to 7.5% a year later.

If we exclude the first 18 months, when the Bank was gaining its spurs, the rate has been no higher than 6% and no lower than 3.5% since. I would argue 3.5% was a bit of an outlier, which is unlikely to be repeated any time soon, so the “normal” range we should be thinking of is probably 4% to 6%. Interestingly enough, the average Bank rate since early 1999 has been 4.8%.

This is worth noting because it is in my view close to the “neutral” interest rate for Britain, which I think is in a 4.5% to 5.5% range. By neutral I mean a rate that is neither restraining nor stimulating the economy. You would expect the rate at neutral when the economy is growing in line with trend, 2.5% to 2.75% a year, and inflation is hitting its 2% target.

Members of the Bank’s monetary policy committee occasionally talk about the neutral rate but it is, if not a banned expression within the hallowed halls of Threadneedle Street, officially frowned upon. I would not expect to find it, for example, in this week’s inflation report.

Sir John Gieve, one of the two deputy governors, came close last month when he talked about the growth slowdown possibly justifying “a progressive shift in policy – from restrictive to a more neutral stance”.

Part of the Bank’s reluctance to commit itself is that a neutral rate implies that monetary policy is more rigid and mechanistic than it is. The neutral rate may not be the same in all circumstances.

Even if you regard it as a useful concept, which I do, there will be periods when the rate has to be above neutral, as it has been in recent months. It is also possible, depending on the impact of the credit crisis and the extent of this year’s slowdown, that we will have to go below neutral. My prediction is of a 4.75% Bank rate by the end of the year. Others are looking for more aggressive cuts.

Recent data have been less than reassuring for those, including King, looking for a rebalancing of the economy but not so bad in terms of growth. The purchasing managers’ survey for the service sector last week was stronger than expected, while its counterpart for manufacturing was weak. The economy is slowing rather than diving, allowing the Bank to pursue a gradualist approach to cutting rates, in contrast to the Federal Reserve. You will know the wheels have come off if the Bank goes into slashing mode.

What about the longer term? Though bond markets have to form a view of interest-rate levels in the long run, it is a brave economic forecaster who does so. Could it be that we have seen the best of low inflation and that rising food and energy prices, coupled with the end of the maximum impact of the China effect on goods prices, mean inflation will be much more troublesome in the next 15 years than in the past decade and a half?

The National Institute of Economic and Social Research, in its latest review, had a stab at projecting rates into the murky future. Assuming growth averages 2.5%-2.6%, inflation is close to target on the CPI and between 2% and 2.5% on a broader measure, the gross domestic product deflator, it comes up with an interest-rate average of 5% for 2009-11 and 5.1% for 2012-16.

That is in the middle of my neutral range and just above the recent average but by no means daunting. After all, it is not so long ago that the norm for UK rates was in double figures. So if anybody asks you for a number on where interest rates will be in 10 years’ time, just say 5%.

PS: Television viewers may be confused. For years, a staple of the schedules has been programmes about how to move up the property ladder. Only antiques programmes have been more popular.

Now we’re seeing the other side of the coin, with a strange Panorama programme last week about the housing market and one from my old colleague Jeff Randall about debt. Does this portend something nasty? – and I don’t mean a crash in the price of antiques.

You know my views but now we have it on the authority of Alistair Darling, in a speech to the Engineering Employers’ Federation last week, that Britain’s housing market should not suffer the woes of America. The points he made are familiar – more responsibility among UK lenders, high employment, low interest rates, tight supply, strong housing demand – but what was significant was who was making them.

You may say the Treasury is programmed to be optimistic. In the late 1980s, however, officials predicted double-figure falls in house prices. If that were their private view now, somebody would have warned the chancellor. Mortgage repossessions last year were lower than feared.

We shall see. Darling is promising to make housing finance a central element of his March 12 budget, including a “gold standard” for covered bonds and mortgage-backed securities and a drive to get people on to long-term (25year) fixed-rate mortgages, though they have not helped in America.

Finally, my mention of Britain’s transport shortcomings and their effect on economic growth created something like gridlock in my e-mail inbox, confirming that this is a national issue. I’ll address it soon. Given that Brown commissioned Sir Rod Eddington to investigate it, it will be interesting to see whether anything has been done on the back of his recommendations made more than a year ago.

From The Sunday Times, February 10 2008

Comments

You seem to be Mr. Interest Rates these days. And at a time when they have never mattered less! What is the fascination with the price of a commodity that fewer and fewer people are selling or buying every day?

Posted by: QED at February 10, 2008 08:12 AM

Echoing QED... David, could you please touch upon LIBOR and credit risk spreads, as well as liquidity issues. Where are we heading?
24bps over libor for BBB commercial paper (April 2007) ... is that repeateable?

Posted by: Michele at February 10, 2008 08:46 AM

Even the risk of default for govt debt is being repriced...

http://www.bondvigilantes.co.uk/media/6/20080208-EMU%20feb08.jpg

Posted by: Minh at February 10, 2008 09:47 AM

Dear David,
Your piece "Bank hikes to 5.75%" (5 July 2007) has an interesting exchange of comments where we debated that a base rate of between 5%-5.3% is about right. Still well within the 4.5%-5.5%
range you list today.
Thanks,
Costas

Posted by: cmilas at February 10, 2008 10:04 AM

"Television viewers may be confused. For years, a staple of the schedules has been programmes about how to move up the property ladder. Only antiques programmes have been more popular.
Now we’re seeing the other side of the coin, with a strange Panorama programme last week about the housing market and one from my old colleague Jeff Randall about debt. Does this portend something nasty? – and I don’t mean a crash in the price of antiques"

The key to understand the future direction of the housing market is BTL. BTL has created demand for home ownership far in excess of the natural demand for house occupancy (hint: rents are static). I think I once read that the average BTLetter has 4 to 5 properties. We have to discount the artificial overvaluation due to BTL - some say 7% - how that will happen? Crash or slow drip? The only reason I tend to favour the former hypothesis is because housing market has historically exaggerated peaks and troughs.

Strange you defined "strange" the programme on Panorama.
Thought it was a reasonable one. And images of the deserted "luxury blocs" on former industrial estates spoke for themselves.

Posted by: Michele at February 10, 2008 11:09 AM

David,

You indeed do seem to believe that the BOE should lower IR's and I had as certain amount of thought that you might just be taking the path of least resistence on this topic. I am not so sure that this will not simply (if it works by encouraging even more spending of borrowed money) create future problems even if a recession now is staved off until after the next election.

I do have to say that Gordon Brown has been praised in the past (even by the Tories) as the most successful Chancellor in generations. Well time will tell with a quarter of employers planning to lay off staff in the next 3 months.

What might be considered in the alternative is that GB created an artificial boom. Scrapping incentives for savings for example by replacing the PEP by the less attractive ISA and most unwisely whilst the market is inundated with excessive liquidity through the BOE pursuing a lower base rate policy perhaps is not the best sign of a prudent Chancellor.

You have said that you do not perceive that there is a housing bubble and I respect that but do not agree. Some economists have said that excessive liquidity is not sensible when higher rates were badly needed to tame any housing bubble there might be.

A feel good factor created by any housing bubble together with perhaps imprudent "equity release" might nevertheless tell on this economy now consumers are no longer relying on an illusion that house prices can go up forever and are no longer accelerating their personal expenditure, or appearing to be in any way attracted to do so.

What might now become apparent is that people ought to have saved a lot more. Was it wise for GB not to advertise this much earlier before the mad spending spree & housing bubble went out of control? Consumers appear now to have spent borrowed money that did not exist.

Japan's housing bubble collapsed in 1990 and the property prices kept going down for as long as 14 years to follow, knocking off 60% of the value of properties (in some extreme cases 80%). It may be worth while to remember a typical Japanese household has 20,000 pounds cash savings (75,000 pounds including life policies, securities, etc), so they have reasonable financial buffer in the event of an economic contingency such as job loss. Still such was the scale of the collapse of the housing bubble.

It will be interesting to see what happens now in the UK economy where people appear to have saved much less. Typical house owners might well be forced to sell out their houses fairly quickly in the face of any financial distress. And employers in this market can make people redundant fairly easily, indeed.

I am sorry to be a doommonger here!

Posted by: Pete Balchin, Solicitor at February 10, 2008 11:49 AM

Not sure there is anything much to respond to here. The whole point about the research from the National Housing and Planning Advice Unit was that the effect of buy-to-let has been exaggerated, and that there is very little overlap with first-time buyers. I've written about interest rates quite a lot recently but then they are the key weapon of economic policy, and there has been movement on both sides of the Atlantic that interest rates are becoming irrelevant can only come from a non-economist. Libor spreads over policy rates have come down significantly, particularly compared with the August-September and December highs, in a way that many people here said they would not.

There are no parallels at all between Japan in the late 1980s and Britain now. If there was anything remotely approaching a parallel, it was with Britain in the late 1980s. Part of Japan's problem since, of course, has been excessive saving.

Posted by: David Smith at February 10, 2008 01:05 PM

HI David

Re Repos, you might want to look at the levels of arrears compared to the 1990's

These are still very low, suggesting that Repos wont take off. However you will also note that repos tend to be occuring at about 3months, this is IMHO a result of the securitisation, which often has clauses that at 3 months, action will be taken.

Therefore although repos might well increase, there isn't the "flood" of them waiting as in the 1990's

Just a thought...

Posted by: kingofnowhere at February 10, 2008 03:36 PM

Food for thoughts... two links showing that sentiment on the UK economy in the mainstream press is turning / or has turned.

http://www.ft.com/cms/s/0/c6070782-d676-11dc-b9f4-0000779fd2ac.html?nclick_check=1
UK on a tightrope
The bank can justify moving toward a neutral interest rate, but would need more evidence of a slowdown before rates could be slashed.
That means that the stagnant housing market will get no immediate support. Nor should it. House prices have risen to unsustainable levels relative to incomes and relative to rents. It may be possible for British house prices to fall without devastating activity in the rest of the economy and that would help the medium-term prospects.

http://www.guardian.co.uk/business/2008/feb/10/housingmarket.creditcrunch
Atlantic drift: will UK housing market follow America into a slump?
'We need to challenge the saying that forced selling, because of people losing their jobs, is what triggers house-price falls,' says Karen Ward, chief UK economist at HSBC.
There is growing evidence that the UK housing market is already slowing sharply. Prices have slipped for three consecutive months, according to the Nationwide measure, and repossessions were already at a 14-year high in 2007.

Posted by: Michele at February 10, 2008 07:35 PM

Do you read any of this stuff before you cut and paste it? Repossessions weren't at a 14-year high in 2007. I did take the trouble to point out to Karen Ward of HSBC that the figures she is using for the house price-earnings ratio are wrong but she is still using them.

Posted by: David Smith at February 10, 2008 07:46 PM

I submitted the links and take no responsibility for the accuracy of the information in them. At the end of the day it is not important what is true but what people belive is true.
Take the two articles below, they convey no factual information, and you may argue even wrong. The KPMG survey is a joke. The article titles are appallingly alarming. Well, you read them in the Times, what is the next thing you do? go out and buy a house?

Britain ‘facing huge job losses’
http://business.timesonline.co.uk/tol/business/economics/article3340863.ece

Banks rake in millions on rate cut
http://business.timesonline.co.uk/tol/business/money/borrowing/article3340710.ece

Let us face it. there are vested interests of those who want a recession and a house price crash. most of them are in EC1, EC2 and in Wall Street. How much money did GS do on the US crash? massive. Fool me once, shame on you. Fool me twice, shame on me!

Posted by: Michele at February 10, 2008 10:44 PM

That's the way headlines often are, I'm afraid. There's nothing wrong with either of the KPMG surveys mentioned.

Posted by: David Smith at February 10, 2008 11:07 PM

"hint: rents are static" i would be careful about that one, different across the country i reckon. Especially in Bankersville EC2 where i am told that a reluctance to buy into the housing market has allowed landlords to ramp up new rental contracts in the order of 20% and renewals between 5% - 10%. Which i find crazy because you'd have to pay me to live in that ghetto.

"perhaps imprudent "equity release" might nevertheless tell on this economy". Not sure if the equity withdrawal argument got enough scrutiny back in spring/summer 2007, there was a lot of research done to suggest that MEW is not representative of those people who borrow against their housing in order to buy consumables. MEW is better linked to re-financings, few people are as stupid as the headlines make out.

Parallels: I think the best macro-cycle parallel which has been suggested in the last 12 months has to be that of US-China political/economic similarities to the UK,Fr-US economic relationship during Suez in 1956. Especially China's timing in announcing its willingness to use its nuclear option (wrt selling off its Treasuries), back in August it hardly got any coverage in the press because of the credit crisis. In fact, the authorities there didn't even try to silence its rebel officials making the threats. Of course back in 1956 the US would not have stood to lose as much as China would if it went ahead with sending the dollar to hell.

Posted by: Johnny Blaze at February 11, 2008 11:15 AM