Will interest rates ever rise?

No one is going to get too excited about the Bank of England’s expected announcement on Thursday that policy rates will remain unchanged. The Bank’s Governor, Mark Carney, has certainly not ruled out the possibility of another reduction from the current level of 0.25 per cent, but the data to hand concerning the economy this summer has been almost as good as the summer itself. The Bank will hold its fire, pending more concrete evidence of the post-referendum economy, and confirmation of what precisely the new government’s fiscal strategy will be. Yet, for all of these deliberations, we might well ask if something is finally beginning to change regarding the outlook for interest rates, if not immediately here in the UK, then elsewhere.

The Brexit referendum clearly hasn’t fulfilled fears that it would precipitate a global crisis—in truth its impact was always going to be much longer-term, and more imperceptibly corrosive—and the global economy is, despite some problems, surprisingly healthy.

Last week the US stock market ended the week on a very sour note, the Standard & Poor’s index dropping by 2.4 per cent amid concerns that US interest rates might rise shortly, perhaps as early as the next Federal Reserve meeting (‪20th-21st September). The catalyst had been the statement by President of the Federal Reserve Bank of Boston Eric Rosengren, who said there was a “reasonable case” for a second hike at that meeting.

His view is not shared by all his colleagues. Lael Brainard, a dove, is one of three Governors who are scheduled to speak on Monday, and financial markets will pay attention to any signals of policy intention this month. It has proven difficult for the Fed to raise interest rates, last summer and autumn, and again in the first half of this year. “Stuff” keeps happening, whether it’s concerns about China, Brexit, or developments at home. Most recently, the August purchasing manager reports for manufacturing and non-manufacturing were both disappointing, dropping by about 3 and 4 points, respectively. The manufacturing index dropped to 49.4 (a reading below 50 suggests contraction), while the non-manufacturing index was the lowest for six years. Further, the August employment figures were seen as firm, but certainly not as strong as they have been. The Fed’s preferred inflation rate, the private consumption deflator excluding food and energy has been inching up, but is still only 1.6 per cent above where it was a year ago.

That said, the nowcasting fraternity, which crunches copious amounts of data to judge what’s happening to the economy right now, reckons the US economy, which has been held back by a sustained inventory correction since late last year, may be picking up to around 3 per cent or so this quarter.

Rosengren’s comment touched a raw nerve, though, which has been grown more vulnerable as a sense is developing in global markets that the post-financial crisis monetary policy cycle may be approaching an end-point. There are a few reasons why markets are starting to flirt with the notion that the interest rate environment may be on the cusp of a shift. And as if to give substance to this change in sentiment, there has been a noticeable, if small, change in the value of government bonds during the last few weeks. 10 year gilt yields have risen back to where they were before the EU referendum, and have risen by 34 basis points since mid-August. German and Japanese ten year government yields have popped back above zero having yielded negative rates for much of the summer. US Treasury yields which never got that far have risen too. These moves certainly don’t mean interest rates are going up soon or much, but they are consistent with a change in expectations about the behaviour of central banks.

And it isn’t just the Fed’s flip-flopping on interest rates that is driving this. The European Central Bank and the Bank of Japan have been leading the charge towards ever greater amounts of QE and negative interest rates for some time, but this summer neither has given financial markets particularly strong reasons to expect more of the same. As the Financial Times’ John Authers pointed out last Saturday, Mario Draghi has gone from talking about “monetary dominance” and having confidence in limitless monetary intervention to appearing rather more as a by-stander at the ECB’s meeting last week.

Meanwhile Haruhiko Kuroda, his counterpart at the Bank of Japan, also once a raging bull on the potency of monetary policy, has sounded more restrained too. The BoJ is due to meet at the same time as the US Fed this month, and it will be noteworthy if the Bank does not pursue more aggressive easing.

The second and third arrows of Abenomics, namely fiscal policy and structural reforms, have in any event been given additional prominence by the Prime Minister this summer. Note also that the whole debate about fiscal policy seems to be undergoing a change. In the UK Philip Hammond will, one suspects, formally bury George Osborne’s fiscal strategy in a couple of months, and the likelihood of a rather softer budgetary stance seems quite high. In the US, both presidential candidates seem committed to a more activist fiscal policy, certainly as far as infrastructure sending is concerned—though the similarities pretty much end at that.

Nevertheless, it is dawning on the political class in many places, finally, that borrowing money at historically low interest rates to finance infrastructure is a policy that could pay both economic and political dividends. Even in austerity-focused Europe, we should expect to hear German politicians discuss the case for “temporarily” easier fiscal policy ahead of national elections next year and in the wake of rather worrying regional election results for Angela Merkel’s coalition recently. France, Italy and Spain need no persuading of the case anyway, but they too may finally find the leeway to “walk on two policy legs” next year, fiscal and monetary.

It may be that this is still the soft overture to a more meaningful change in the music to which interest rates and bond markets dance. We have been here before, and it is still possible that after a brief flirtation, markets will remind us that the world economy isn’t changing for the better after all, or that inflation is rising. But commodity prices are firmer this year, China isn’t imploding and the government will move mountains to make sure it looks stable before next year’s 19th Party Congress, and Brexit fears were misdiagnosed. If the political drivers of policy-making are changing in ways suggested here, and central bankers themselves are starting to believe that they have reached the limits of their brief, some rise in interest rates, which to many has become folklore, may emerge from the mists before long.