Higher rates can wait

INVESTORS lulled into believing that low interest rates would last for ever got a cold dose of reality this month. First, Mark Carney, the governor of the Bank of England, told an audience in the City that rates could rise “sooner than markets currently expect”. Now America’s Federal Reserve, which like the bank has kept rates near zero for more than five years, has signalled its intention to keep them there at least until next year; but it too faces ever louder calls, including some from its own officials, to abandon that pledge (see article).

Advocates of fast action worry that rates left near zero for too long will cause inflation to accelerate in both countries. And they fear that even if prices stay quiescent, too much cheap money for too long is inflating asset bubbles: their eventual popping will create another financial crisis. These worries are not unfounded. But they are exaggerated.

Start with inflation. At 1.5% in Britain (the lowest rate in four and a half years) and 1.6% in America, it is below the 2% target of both countries’ central banks. Of course, central bankers should fret not about today’s inflation but tomorrow’s, and the vigour of Britain’s recent growth means the country’s spare capacity is disappearing: unemployment has dropped to 6.6% from 7.8% a year ago. But there is no pressure on wages. In America, the price picture is even more benign: the slack is greater, and inflation has been below target for two years. As in Britain, meagre pay rises give no hint of a wage-price spiral.

What about financial instability? Froth is certainly evident. In Britain the main exhibit is house prices, which have surged by 10% in the past year, overtaking pre-crisis levels. Household debt is also on the rise. In America the appetite for risk is most obvious in the fixed-income market: loans to highly leveraged companies this year are on track to match last year’s record-breaking $1.1 trillion. A third of these loans lack the usual covenants that ensure borrowers can repay the money.

Give surgery a try

These excesses are worrying, especially given the wretched history of the 2000s, when the Fed stood by as an enormous housing bubble inflated. Yet higher rates now are the wrong response to the latest signs of excess, for three reasons.

First, the excesses are still small, compared with those that brought down the global economy in 2007. Britain’s housing bubble is largely limited to London. And in both Britain and America banks sit on thicker cushions of capital and liquidity, making them less vulnerable to any downturn in asset prices.

Second, central bankers and their fellow regulators can treat financial excess far more surgically today by using “macroprudential” tools rather than the blunt instrument of interest rates. The starting-point with mortgages is usually limiting loan-to-value and debt-to-income ratios, but, importantly, allowing some flexibility for the riskiness of various borrowers. (Canada, for instance, is stricter with buy-to-rent investors than with homeowners.) Banks can also be compelled to hold more capital and liquidity against risky loans. And to the extent that macroprudential measures slow down the growth of assets, debt and wealth, they delay the need to raise interest rates, so safer loans remain cheaper for longer.

Third, the danger of raising interest rates to dampen down asset prices is much bigger now than it was ten years ago, because rates are near zero. Premature monetary tightening could push the economy back into recession and turn inflation to deflation. The result would be to send interest rates back to zero for even longer.

To be sure, macroprudential controls are untested. Applied too roughly, without allowing for the creditworthiness of borrowers, they too could be fairly blunt. But they are a better first line of defence against bubbles than just raising interest rates. Central banks would end up creating far more financial instability if, in their zeal to deflate bubbles, they kill the recoveries they have so carefully nurtured. Better, for the moment, to leave interest rates alone.