Interest Rates Will Return to Normal, Whatever That Will Be

Negative inflation and negligible interest rates confirm we are living in extraordinary times. But before asking when things will return to normal we should question what now constitutes normality.

I spent much of my life thinking any interest rate below 10 per cent would be low. That rule was rewritten in the 1990s, however, with the new norm of cheap money â€"- a regime now blamed for causing the current financial crisis.

Yet the solution to the crisis is to cut rates even lower to provide a temporary stimulus to demand. At some points the temporary rates must rise, therefore, but how far? And will a return to a normal (whatever that means) level curb the recovery?

The first increase will be the most dramatic, however small, because it will signal an end to emergency rates. Indeed interest rate movements usually have more psychological than financial effect. When interest rates were always in double digits they were typically raised by 2 percentage points as a scare tactic and then dropped in a series of quarter-points in the hope the small falls did not undo the effects of the big rise.
In today's inverted economics deep cuts achieved the shock value but the small rises must follow. But while that may worry borrowers, it will be a signal the authorities think the worst is over.

This time the Bank of England also has a quantitative easing programme to unwind -â€" its £125bn (so far) printing of money. Even if you doubt whether this has made credit more freely available it risks a negative effect as the Bank resells its acquired assets.

Will that unwinding and higher interest rates dent consumer demand? In theory low rates give savers an incentive to spend but in practice, recession encourages them to put away more for rainy days, despite the rates. And with credit cards rates still in the mid-teens or higher, the marginal cut has provided little incentive to spend more. Only the falls in mortgage rates have put real money in the public's pockets and increases â€"- fixed rates are already rising -â€" will make people worse off.

It is those mortgage cuts that made RPI (Retail Price Index) inflation negative and increases will reverse that trend. But with home-loan costs too low to go lower, their effect on the RPI will drop away after a year anyway, pushing inflation upwards again and that will lead interest rates back up.

When? Early next year could be the turning point for both inflation and interest rates. And how far will they rise? The government is sticking to its 2 per cent target for CPI inflation, the calculation that excludes mortgages, but it would take little to make RPI the higher rate again. As for interest rates, a 5 per cent norm seems as round a figure for the new economic era as 10 per cent was in the past.

But remember, in cyclical markets, normal is a point that rates pass through on their path between extremes.

(Pic: woodleywonderworks cc2.0)