Are Interest Rate Hikes Coming?
Mar 09, 2022 11:59 am
Hey friends,
I made a smidge more progress on the wood store this week with a box for the kindling.
Built from slotted angle iron lying around in the garage it made a solid frame to which I could attach wooden boards on the side and top. I'm never sure which option to choose for cutting metal. I've tried the metal cutting blades in my mitre, circular saw and my jig saw. All work well. This time I tried a metal cutting disk with my angle grinder which also did the job and created a lot of sparks which was good fun.
I got a new Oregon chain for my chainsaw which is a lot sharper than the one that it came with. I can recommend ChainsDirect. They're a bit cheaper than Screwfix and the chain came within a couple of days.
All this sawing and chopping of wood took up most of the weekend so there's not a lot to show on the DIY front this week so I've written about interest rates instead.
📈 Are Interest Rate Hikes Coming?
That seems to be the received wisdom at the moment. Inflation is high and there seems to be more price pressure coming down the road given the war in Ukraine. Disruptions to the grain and fertiliser markets will increase food prices and reduced supply of Russian energy will affect pretty much the price of everything.
What is inflation though? It comes down to too much money chasing too few goods and services.
In times like these the playbook states that interest rates should be raised. This has the following effects on inflation:
- Borrowing becomes more expensive. Businesses and consumers borrow less due to higher costs. This means less spending.
- Mortgage interest becomes more expensive. This isn't optional borrowing for those who already own so when this cost goes up other spending must come down. Again, less spending overall.
- People destroy money. Okay hear me out on this one. When a bank makes a mortgage loan of £100k for example, essentially they take a big fat nothing - a zero, split it in half and put £100k in the borrower's hand (the liability) and minus £100k on their own ledger (the asset). Magic money out of thin air, and it's where most of our money comes from. If the rate the borrower is paying on that mortgage goes up significantly then they will be more likely to use excess income to pay down the mortgage capital rather than spending it elsewhere. Over time this reduces the liability and asset back to £0. The money is destroyed. Less money and less spending = less inflation.
- Savings increase. If you can get a decent return in a savings account it encourages saving more and spending less.
- There are others but you get the gist.
So as you can see raising interest rates only really tackles one side of the equation - the too much money side. About a year ago it was probably fair to say that this was indeed the issue. Many had saved a lot during the lockdowns due to reduced commuting and socialising and had a fair amount to spend when things opened up. Additionally the BoE and other central banks had unleashed an extraordinary amount of moolah through quantitative easing (QE). There was a lot of money sloshing about.
But that's likely not the problem now as most of it has worked its way through the system. The problem is the supply side. As we've talked about many times there's not enough energy, timber, garden furniture, computer chips, cars etc to go around. And raising interest rates won't really solve that. In fact, the press are talking about a cost of living crisis (their favourite word) so squeezing us harder with higher interest rates doesn't seem to me to be a good solution.
Additionally, the status quo suits the government very nicely. High inflation erodes our £2 trillion+ national debt while low interest rates makes our payments lower.
To ensure this isn't all one sided, there's at least one pro for raising interest rates in relation to the current inflation we're experiencing. As we're a net importer here in the UK it helps having a stronger pound as fewer pounds are required to import something. That provides a deflationary pressure. This happens because higher interest rates attract more savings in pounds from those both at home and abroad ('hot money') and this demand for pounds strengthens the currency. This is why Russia doubled its interest rate to 20% last week to try to support the crumbling ruble. Crimea river.
So I'm not saying interest rates won't rise at all, I think they could well do but probably not significantly. Even if they do but the economy continues to chug along well enough and lenders still want to lend then they could squeeze their own margins rather than passing it on to us.
Strangely enough though the problem with inflation might be solved by...inflation. I had an email today from someone who was quoted £7k to clad his GR in cedar 🤯. Very sensibly he is going to stain some softwood featheredge instead. There will be plenty of other people making coming to the same decision, reducing the demand for cedar and so eventually reducing prices until demand matches supply. While there are things that can't be dropped like energy, food or petrol there is plenty of discretionary spending that can be reined in in response to high prices.
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So that's my contrarian take. The BoE will be acutely aware that there is no easier way of causing a recession than to raise interest rates too high too fast. The curious thing is that we appear to be trapped in a low interest rate environment. Each economic cycle brings lower lows. Check it out:
Since about 1990, bar a few small increases, it's been downhill all the way and from 2008 onwards it's been pretty much static. The highest we got to was 0.75%.
The trend seems to have been longer still; much longer:
We're running out of graph! Some think that the future is deflationary as technology reduces prices - think of TVs today vs 10 or 20 years ago, they are much cheaper (and much better). How do you combat deflation? You lower interest rates but we can't unless we go negative which brings about a very strange world where you get paid to take a loan.
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I think this is the third or fourth time I've tried to tackle an economics piece on this newsletter. The previous times I've ended up pressing the delete button because it becomes a complete minefield of possible tangents to go down due to the interconnectedness of the variables. I guess that's why no two economists agree completely. So there's plenty I left out here and plenty more I admit to not understanding.
It's fun though to try to peer into the future and in a year or two we can come back and say either I'm a genius or laugh at how wrong I was. I've got my excuse lined up already though - my approach was right and the BoE simply didn't agree with me 😉.
What do you think will happen with interest rates?
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