The case for higher interest rates is clear. The US economic recovery is well established, having begun in 2009. Output is now 10pc above where it was at the beginning of 2008, just before the financial crash unleashed the Great Recession. Unemployment has fallen to 5pc, very nearly as low as the lowest levels that reigned before the financial crisis.
It is true that inflation remains subdued, but this is largely due to the influence of low oil and commodity prices. If you strip these out of the index to reach a measure of “core” inflation, the rate is about 2pc.
Moreover, it needs to be borne in mind that the ultra-low interest rates that have ruled for so long were an emergency measure. Accordingly, with the emergency over, and as the economy gradually gets back to normal, then interest rates should also be returned to something like normal.
Admittedly, the new normal may not be quite the same as the old normal. The Fed has itself made clear that the pace of monetary tightening is likely to be slower than in previous economic cycles. Equally, the peak of interest rates is also likely to be lower than in the past. Indeed, if rates do rise this week, there will surely be an accompanying statement conveying something like this now familiar message. Accordingly, the markets, pretty much to a man, confidently expect interest rates to rise slowly and to reach only about 1.7pc by the end of 2017.
This confidence is all very well but the history of economic forecasting and of economic policy is a history of mistakes. When thinking about the future, we (and they) need to take heed of this experience. In the past, it has been common for central banks to raise interest rates too little and too late. The result is that they have been left to play catch-up while inflation increased. The awkward truth is that inflationary pressures can readily take both markets and policymakers by surprise. This is a particular danger when, as now, inflationary impulses are disguised by the powerful disinflationary forces unleashed by lower energy prices and the strong dollar.
US rates at 3.5% by the end of 2017 is a bold forecast by Roger Bootle, who has an excellent track record. So what would need to occur for his prediction to be accurate?
The first point, I maintain, would be a rise in global commodity prices. Today, many commodities are at unsustainably low levels, so supply is likely to contract in 2016, while demand continues to rise.
We are also likely to see some additional growth in other regions of the world – China, India, Japan and Europe, as they are benefitting from accommodative monetary policies in addition to low commodity prices.
With economic growth spreading to more countries and interest rates rising from extremely low levels, we would see bearish trends for bonds but a mostly bullish environment for equities, at least initially.
However, if I am too optimistic in term of global economic recovery over the next two years, then I do not see how US interest rates can rise to 3.5% by the end of 2017. That would propel the Dollar Index higher, weakening the US economy in the process.Back to top