How much further will the Federal Reserve have to raise rates? This week it added some flesh to America’s skeletal interest rates when it raised them by a quarter of a point, to 1.25%. The market predicts that rates will gradually rise to 4% or thereabouts by the end of next year. The economy is skipping along nicely and rates, after all, are still very low. But the market is also starting to fret about inflationary pressures. Indeed, some — this newspaper included — think that the Fed has been too sluggish: with monetary policy still loose, inflation is likely to creep upwards. But the outlook for interest rates will be quite different if inflation is not America’s biggest economic problem. A fascinating paper, “Dicing with Debt”, by Stephen King, the head economist at HSBC, a big British bank, explains why it might not be.
Mr King’s starting-point is that the Fed and other central banks need not have been as worried as they were about the threat of deflation. Certainly, debt deflation is a particularly malign economic beast, which emerges when people curb their spending in an effort to pay off their debts. Those very spending cuts cause prices to drop, and force up the real value of debts, creating a vicious spiral. As the experience of America in the 1930s and Japan in the 1990s shows, central banks can do little about this, because they cannot set interest rates lower than zero. It was fears of just this sort that caused the Fed to slash interest rates 13 times, to anorexic dimensions.
Most commentators have cheered Alan Greenspan and his colleagues at the Fed for being so aggressive in warding off the deflationary threat caused by huge corporate debts and the popping of the stockmarket bubble. After all, one of the shallowest recessions on record was followed by a strong recovery in which bumper profits enabled overly indebted companies to reduce their debts to more manageable levels.
Mr King is not among those cheerleaders. He argues that the Fed was wrong to cut interest rates so much, because much of the deflationary pressure was of an altogether more benign sort: a reduction in overall prices caused by rapid technological change, improvements in the terms of trade and other factors. Britain had long periods of “good” deflation in the late 18th and 19th centuries, when nominal interest rates and growth were both strong. In recent years, argues Mr King, there has again been deflation of just that sort, and for similar reasons. Technological change and the integration of China, and increasingly India, into the global economy have pushed down the price of traded goods in America, thus pushing up real incomes. “And, because of these real gains, any rise in real debt levels will not be a source of potential ongoing instability,” writes Mr King. Alas, because the Fed’s perceptions of deflation have been coloured by the experiences of America in the Depression and Japan in its lost decade, it reacted by reducing interest rates sharply, a response that is more likely to bring about the debt deflation it most feared.
High real growth — so long as deflation is of the good sort — requires high real interest rates. If rates are too low, people borrow too much and spend it badly: what Mr King calls “happy investment rather than good investment”. For a given level of nominal interest rates, a fall in prices will deliver the appropriate level of real interest rates. But by cutting nominal rates to prevent deflation, the Fed has reduced the real rate of interest too much.
Evidence that this has been the case comes in two forms. The first is that borrowing has ballooned in America in recent years. Any reduction in the indebtedness of American firms (under immense pressure from the capital markets) has been more than matched by borrowing by consumers and the government. Even though interest rates have been so low, the proportion of household income that is spent on servicing debts is at record highs. The government’s stock of debt has been rising rapidly: this year, its budget deficit is likely to be 4.7% of GDP. This is why America’s current-account deficit has been rising: as a country, America borrows too much.
The Trouble with Cheap Money
Here is where the second piece of evidence comes in: what Americans spend their money on. If money is too cheap, then rates of return will fall, companies will tend to use capital rather than labour, and people will spend money on riskier assets; on things that have little to do with underlying economic growth; and on things that are in short supply. As it happens, this is a decent description of America in the past few years. Companies have been slow to hire workers even as the economy has bounded along; and workers’ share of national income is very low. The low cost of capital has, moreover, encouraged speculation in risky assets, such as emerging markets, or — closer to home, as it were — property. And, yes, with all that money sloshing about, it has also pushed up inflation a bit.
When economic growth is fuelled by asset prices and debt, pushing up interest rates is likely to have an effect only in so far as it affects expectations about the prices of those assets. This creates huge problems for policymakers. Will a small rise in rates have a small effect (because, say, expectations about further rises in house prices are so entrenched)? Or a big one (because people expect more rate rises)? Whatever the answers to these questions in the short term, at some point, says Mr King, attitudes towards asset prices and debt will have to change.
There is thus a distinct danger that by pushing real interest rates back to where they should have been in the first place, monetary tightening will reveal the economic recovery to have been more fragile than most think—and threaten a hard landing and the malign sort of deflation that the Fed was so keen to avoid. This could even mean that rates need to fall next year, not rise. And with rates so low and budget deficits already high, America’s economic armoury is much depleted.