At last the US raises rates…but we don’t need to hurry

Like patients dreading the onset of a serious illness, countries across the world have been anxiously watching the United States since the summer of 2013 when the then head of its central bank, Ben Bernanke, started signalling that tighter monetary policy was on its way.

Some 30 months later on 16 December his successor Janet Yellen has finally delivered on what must be the most telegraphed and long awaited rise in interest rates.

The net result might look insignificant - the main official rate went up from a range of zero to 0.5% to 0.25 to 0.75% - but there is no doubt it is significant that the US Federal Reserve effectively raised the cost of borrowing money for the first time in almost a decade.

As well as being well signalled, the move was justified by the economic data. Unemployment has been falling - 211,000 jobs created in November alone - and inflation rising, hitting 2% in October. Lastly Yellen has been sending out signals to the markets and inaction would have caused huge ructions.

No-one likes higher borrowing costs but American businesses and households should be able to cope. But it is the impact on other countries that has seen the most intense debate.

The focus is primarily on emerging markets that found capital flooding in while many of them enjoyed strong rates of growth even as the US enjoyed only an anaemic performance.

As the dollar and wider market interest rates start to rise governments and companies that borrowed in dollars to get the cheap rates will find higher rates and falls in the value in their domestic currencies against the dollar make those borrowing costs a lot more painful


Closer to home the focus has been on whether the Bank of England will follow suit as part of a coordinated tightening of monetary policy.

Many commentators have started to pencil in a hike in UK rates from their historic low of 0.5%.

On the surface it’s easy to see why. The UK has enjoyed 11 consecutive quarters of economic growth, business investment has been expanding through the year, wages starting to pick up and public finances, according to the latest Autumn Statement, are likely to improve over next five years.

Yet, there are very good reasons not to rush. Britain’s homeowners and credit card borrowers are very sensitive to rising interest rates as households have been taking on more and more debt.

Secondly, the Autumn Statement pointed to a steeper round of spending cuts and tax rises over this parliament than Britons have already had to cope with. Since cutting government spending tends to have a contractionary effect on the economy, hiking interest rates at the same time would double the pain.

Overall public spending is meant to fall to 36.5% of national income in 2019/20 - down from 39.6% in 2015/16 and 45% in 2009/10, the lowest since 2000/01. It has touched this level only four times since the Second World War. As John Van Reenen of the London School of Economics points out, this is a “shrinking of the state on a spectacular level”.

Finally, inflation remains low, well below the target of 2% set by the government. The collapse in oil and commodity prices to new low levels that look likely to be maintained will do little to add to those pressures. Indeed the figures on wage growth published the same morning as the Fed’s decision showed that the growth in average annual earnings dipped to a 10-month low of 1.9%.

The reality is that an economy which has enjoyed moderate growth, minimal inflation and stagnant wage growth is hardly a verdant ground for higher interest rates. And of course any resulting rise in sterling’s exchange rate would make only make life worse from our long-suffering manufacturing exporters.

Strange though it may be to say, monetary policy could actually be weaker in a year’s time. If the Bank of England continues to hold back from raising rates while the Fed carries on hiking, market interest rates that were based on an expectation of higher UK borrowing costs will swiftly fall to accommodate that new view. That would be a relief to businesses and borrowers.

If we look across the Channel rather than the Atlantic we can see that the European Central Bank is doing the exact opposite: cutting its deposit rate from -0.2% to -0.3% and extending its quantitative easing programme for six months to March 2017 - a decision that takes the size of its bond buying to €1.46tn.

Trying to make sense of it all? Well, perhaps the best place to be, borrowing a line from the 1970s band Stealers Wheel, is to be stuck in the middle between those two.

More about the author

About the author

Phil has run Clarity Economics, a London-based consultancy, since 2007 and, before that, was Economics Correspondent at The Independent.

Phil won feature writer of the year Work Foundation Work World media awards in 2009, and was commended by the Royal Statistical Society in 2007.

He is the author of Brilliant Economics and The Great Economists.

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