Belfast Telegraph

Interesting days ahead in quest to gain stability

By Hamish McRae

I don't think it is going to happen but we can't rule out the possibility that UK interest rates will go up this week. It is more likely that the first rise, by 0.25% to 0.75%, will be in May.

But what is beyond dispute is that 2011 will be the year when interest rates around the world start to climb back towards more normal levels.

So we had better start thinking about the consequences of that.

The game-changer was the clear signal from Jean-Claude Trichet, the president of the European Central Bank, that it may increase rates next month.

Of course the Bank of England does not have to follow the line of the ECB - we have an independent monetary policy - and Britain's circumstances and needs are different from those of the eurozone.

But global interest rates, at least within the developed world, tend to move loosely in synch, with Europe and the UK somewhat closer than the link with the US.

(The fact that the dollar remains the principal reserve currency and that the US is a less open economy than the major European ones gives the US a policy freedom other countries do not have.)

So when Europe moves I don't expect us to be far behind. Why is it now odds-on for Europe? Central banks do not set rates in a vacuum.

They only have control over short-term rates as the longer the term of the deposit or security, the greater the influence of the markets.

Thus 30-year government bond rates are entirely set by markets and 10-year ones mostly so.

If a central bank is seen to be too soft on inflation, long-term rates will rise. And so in setting the short-term rates, central banks have to work within the inflation outlook for the economy.

There is a theoretically "correct" interest rate, called the Taylor rule, developed by Professor John Taylor of Stanford University.

Put simply, the central bank should take into account the actual inflation compared with the target rate of inflation, and the actual output of the economy compared with its full capacity output.

If actual inflation is above target rate, interest rates should go up. And if actual output is below potential output they should go down.

It is a wee bit more complicated than that but you see the principle. Of course, the Taylor rule should only be used as a guide, and the periphery of the eurozone is still in intensive care and can use artificially low interest rates.

But eventually, monetary policy, like fiscal policy, has to come back to normal and you can make the case that if everyone sees you have to do something you had better get on with it. And so it will be with UK interest rates.

The British economy feels a little weaker than the core European one and we have a worse fiscal situation than France or Germany, but we also have a worse inflation problem.

There are practical arguments for waiting until after the Budget, but let's see what the monetary committee does this week.

The main thing to get our heads around is that this strange period of near-zero interest rates is coming towards its end.

You then start to think about what this might mean.

Most obviously, might higher rates abort the global recovery? Will they hit the housing markets? What will they do to share prices? What does this do to tensions within the eurozone?

If America is tardy in increasing rates when everyone else does so, will there be a run on the dollar?

I suppose my main thought is that we should be no more worried about rates going up too quickly than we should be worried about them going up too slowly.

In 18 months' time rates here and in Europe are likely to be between 2% and 3%.

By any historical standards that will still be very low, maybe even below the rate of inflation. In any case I think we know that availability of finance and willingness to borrow are more important than the notional rate of interest set by the central bank. Housing markets? It's hard to generalise because not only are national markets very different but so too are regional ones - witness the boom in upper-middle and top-end homes in London and slack conditions in the Midlands and North. As far as the UK is concerned, some modest rise in rates coupled with better access might support prices better than the present cheap money.

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