Interest Rates Rise in the UK - Essay Example

ECONOMICS & FINANCE ASSIGNMENT (2008, 3000 words) " The impact of steady increase in the interest rate in the UK in the last two years " Contents:- Introduction Aims & Objectives Main Discussion Conclusions Bibliography INTRODUCTION We have seen over the course of several years the wide reaching affects of low inflation and low interest rates that have allowed the economy in the UK to develop, grow and expand. At the same time the cost of production and export have been relatively high in comparison, which has allowed the cheaper import of goods and some services that have impacted on UK manufacturing and productivity. In this respect, it can be found that it is far cheaper to produce goods overseas and import into the UK, rather than manufacture from scratch in the UK. This has resulted in many large manufacturers, in particular those who provide retail goods in the clothing and leisure industries to wholesale manufacturing to Asia where productivity costs are much lower. These effects caused by a low inflation, low interest, but highly tax economy are the outcomes that are a current and continuing to thwart economic competitiveness and equilibrium across the UK manufacturing base. This assignment therefore seeks to consider some of the reasons for the causes and effect of increase in interest rates that are now providing causal effects across the economy. In particular the economy of the USA, that has been a focus of concern across financial sector industries in the UK. In doing so we will consider literature from both the UK and USA, in particular papers from both academic and financial institutions that impact and influence the wider economy. AIMS AND OBJECTIVES To consider how interest rates have affected the changes in the economy, in particular, the way in which the USA economy impacts upon the UK and to some extent the Global economy. Why have economic policies affected UK interest rates to such an extent How far reaching has the economy been infected What are the extended affects that are impacting on the UK interest rate MAIN DISCUSSION The Governor of the Bank of England, addressing the House of Lord's select committee, offers some explanation: Commenting on the effect that world interest rates have on domestic interest rates, Mr King said that: "We look at the balance between demand and supply, we ask ourselves what goes into that balance and there is no doubt that what is happening in the rest of the world is a key input into that assessment. However, the way in which overseas interest rate changes affect our judgement is solely as an input into that judgement." "all central banks are very clearly focused on meeting their own price stability objectives. Of course they take the rest of the world into account, but they do not say 'Oh gosh, Jean-Claude has put up interest rates, perhaps we ought to keep up with him'; it is not like that" (House of Lords 2006 p.10). Therefore, the economics of equilibrium are a force that has to be recounted in that the elasticity of the economy is a crucial aspect of financial housekeeping in all World economies and despite the fact an economy must predominately consider its own fiscal policies, rather than being affected by other economic decisions. The problematic area of asset is also a crucial factor when considering the level of impact on an economy, in the same report, the select committee discussed the recent developments in asset management in the USA which has infected the relational economies that have relied on in particular, citing Mr Ben Bernanke, Chairman of the US Fed. stated that: Part of the problem concerning the relation between money growth and inflation is that for many households money holdings are an asset, as they are a form of saving as well as a source of potential purchasing power. The down-turn in stock markets in 2000 may have caused a flight into money and so begun the growth in M4. With the growth of non-bank financial intermediaries, and the increased use of mortgage withdrawal based on the security of a real asset, conventional monetary aggregates do not convey the same information about liquidity as in the past It applies equally to the United Kingdom. This is one of the reasons why the Bank of England takes account of a wide range of information (p.11). This concern surrounding the wider implications of held stocks and assets are a conclusion found in the work of Grossmann & Jackson (2005), who suggest that, there is sufficient literature across academic circles that have investigated successfully the impact of interest rates affected by asset management: Rigobon and Sack (2004) find that an increase in short-term interest rates leads to decreasing stock prices. Also, Thorbecke (1997) finds significant evidence that an expansionary monetary policy leads to an increase in stock returns. Additionally, Thorbecke and Coppock (1996) investigate the impact of monetary policies on small and large firms and find different results with respect to contractionary and expansionary monetary policy. Finally, Jensen et al. (1997) considers the impact of interest rate changes on different industries and find that all industries, except the oil industry, react positively to rate decreases and negatively to rate increases in both the short- and long-term. Interestingly, they find that the strongest reaction is associated with the construction and finance industries, both commonly considered interest rate sensitive (p.8). Nevertheless, what is found in Grossmann & Jackson (2005), is that it is felt by many of the academics cited that the USA economy impacts in particular on the European Central Bank (ECB): announcements by the ECB will always be viewed as providing less information than those by the FOMC, as several previous researchers have pointed out that world markets are in general held hostage by U.S. macroeconomic announcements. For example, Nikkinen and Sahlstroem (2004) investigate the impact of ECB and FOMC meetings on the German and the Finnish stock markets and surprisingly find that the ECB meetings have no impact on the domestic stock markets, but the FOMC meetings do (p.9). Therefore, we can see that the USA economy in particular assets and stock economics have and do have impact on domestic monetary policies and interest rates, far reaching than those in EU states. Interestingly, Warnock & Warnock (2005), suggests that: "large foreign purchases of U.S. bonds have contributed importantly to the low levels of U.S. interest rates observed over the past two years"; (p.24) [and that consequently] "Foreign buying of U.S. bonds has clear benefits for the U.S. economy. For example, by helping to keep interest rates relatively low, foreign buying has lowered borrowing costs and spurred economic activity" (p.25). The UK is one of the World's highest debt economies, in that there are more borrowers per head of the population than savers, this has a clear knock on effect across the economy in that interest rates are commuted at high levels of return. The Bank of England in it recent study by Drehmann et-al (2008) noted that: Credit and interest rate risk in the banking book are the two most important risks faced by commercial banks. Credit and interest rate risk reflect the possibility, respectively, of a borrower failing to repay her debt and of a fall in a bank's profitability due to a change in interest rates. While banks and regulators are aware of the importance of both risks, they tend to manage these risks separately. However, credit risk and interest rate risk are intrinsically related to each other and not separable (p. 5). This concern is found in other literature (Drazen & Hubrich 2002; Faini 2005) each suggesting a clear link between US fiscal policies and interest rates. Faini (2005) clear cited that: "the interest rate spillover effects of fiscal policies slippages in high debt countries are relatively larger than the average. Fiscal indiscipline in high debt countries has a stronger impact on interest rates, which is reflected not only in higher domestic spreads but also, after the onset of EMU, spill over to the area wide level of interest rates" (p.34). In further investigation the literature provides answers to this concern. In a buy now pay later economy like the UK and the US, we can find that higher levels of borrowing to obtain better housing, combustibles and other similar assets results in the levels of borrowing that are higher than normal or as fiscal policy should dictate. Therefore, we find, as borrowing is excessive so the real cost of living increases to be able to support the levels of supply and demand that are needed to maintain a stable economy. This gain is reflected in the literature. Faini (2005) study on the EMU of which the UK is a partner, offers some stark reading, and supports the notion of this causal effect of poor disciplined fiscal restraint: What this paper shows is that the findings for the US and EMU can, at least partly, be reconciled when one recognizes that an expansionary fiscal policy in one EMU member will have a twofold effect, first on its spreads, and second on the overall level of interest rates for the currency union as a whole. What our results suggest is that the latter effect is much more significant, indicating that there are indeed substantial spillovers, through the interest rate channel, among member countries fiscal policies. A further finding is that for high debt countries sustainability is a relevant issue. Both the level and the dynamics of public debt stock have a strong influence on their domestic spreads (p.35). The level of borrowing again is seen as a clear problematic and causal effect on interest rises, as indeed are the fiscal policies that have and still do encourage such levels of borrowing and spending. Faini (2005) study further suggests that: The need for both fiscal coordination and fiscal rigour does not arise solely from the desire to allow fiscal policy to play an autonomous role in macroeconomic stabilization, but more fundamentally from the existence of unfavourable interest spillovers among EMU members. At the same time, we find some evidence that the spillover effects are stronger for high debt countries with unsustainable fiscal policies and, hence, a growing debt burden (p.35). Nickell (2005) in his lecture to the British Academy support the view that liberal fiscal policies have extended borrowing to such an extent that householders are now paying a high price for their borrowing: Interestingly enough, the overall rise in household debt over the last eight years has not had a big impact on consumption growth because, over the same period, there has also been a significant increase in the rate of accumulation, by households, of financial assets. Finally, while it is possible that higher levels of debt may make household consumption more sensitive to interest rate changes, this may easily be offset simply by moderating these same changes (p.32). Therefore, the causal effect on the economy surrounding the wide and far reaching borrowing is change in fiscal policy that increases interest rates, lowers the thresholds and conditions of borrowing to high risk customers. Which in turn tightens the equilibrium of the economy in the long term. The wider implications are Global in that we have seen the level of oil and gas stocks increase and the level of imports and exports become tighter. The level of insolvencies amongst business sector organisations is much higher, the cost of living has expanded and the widening of the unemployment levels. This in turn has brought about a level of strength in Sterling and placed greater pressure on consumers (Lewis 2006- p.2). This has resulted in a slow down in the housing market, with affordability gap widening as the market slows down. With the significant rise in utility prices consumer spending should tighten. The downside being a rise in local authority charges, mortgage rates and slower consumer spending, due to the many businesses that; are stamping down on labour costs (Lewis 2006 p. 3). The causal effect of raising interests according to Drazen & Hubrich 2002) states that: Raising interest rates signals that a government is committed to fixed exchange rates, but also possibly weak fundamentals. Hence, a key empirical implication is that raising interest rates leads to the expectation that future rates will be high, but may also increase the probability speculators assign to collapse. This is the mixed signal (p.3). The mix signal has been seen in the level of recent stock market and mortgage borrowing in that speculators do not take kindly to inflation, or uncertainty (Lewis 2006 p.1). Therefore, it is clear that the careful management of fiscal policy is less understood, than implied. In that according to the House of Lords Select Committee on economic affairs (House of Lords 2006) we can see that: "If interest rates were to affect asset prices in a predictable way, then this mechanism would provide a better understanding of how interest rates affect inflation" (p.9). This reveals a level of understanding concerning the macroeconomic effects on our economy, in that inflation can be unpredictable, furthermore; according to the Committee (House of Lords 2006): " The implications for inflation were different. Rachel Lomax; Deputy Governor, said that the relation between house prices and consumer spending was an incredibly difficult area, not at all well understood (p. 9)". Therefore, a greater understanding and clarity surrounding consumer spending is needed to prudently understand complex microeconomic systems. According to Fiani (2002): While the economy is Keynesian in the short-run, so the increase in aggregate demand raises national income, in the long run the economy is classical and output is determined on the supply side. Fiscal policy still affects interest rates, though: the increase in the budget deficit leads to a fall in domestic saving (provided that changes in private saving do not fully offset the fall in public saving), a decline in investment, and hence a lower capital stock. The consequent rise in the marginal productivity of capital will, in equilibrium, be associated with an increase in the real interest rate (p.3). Grappling with the finite economic principles is not for the faint hearted, in that much is still to be understood. The extended effects that are impacting upon interest rates are far and wide reaching, in that they affect both the levels of consumer spending and financial returns on investments. Furthermore, according to the House of Lords (2006), even those who are deemed to understand are still learning: [asset prices] may well be an important part of the transmission mechanism from interest rates to expenditures on goods and services. As this does not seem to be sufficiently well understood, we urge the Bank of England to undertake extensive research on this issue (p.8). CONCLUSIONS The inconsistencies in the literature are a clear understanding of macroeconomics, this is a fundamentally intense area of study that is often grappled or cobbled over to inform and arrange fiscal policies. There are differences between the USA and UK as to their understanding of such complex economic systems. Similarly, we can find that there is little understanding between inflation and consumer demand, which has been born out in the House of Lords (2006) report. Nevertheless, we can see that both interest rates and inflation appear to have far reaching cause and effect upon the consumer. The problem for the economy is that despite good sound economic principles we still grapple as a society with the fundamental basics that move forward our economies. The 'knock on' effect being, interest rates and inflation. Therefore, in conclusion we can maintain that interest rate rises have curtailed customer spending as a mechanism to cool the economy and contain inflation. BIBLIOGRAPHY DRAZEN, A, & HUBRICH, S, (2002) Mixed Signals in Defending The Exchange Rate: What Do the Data Say *Tel-Aviv University, University of Maryland, NBER, and CEPR; and McKinsey Consulting, DREHMAN, M, SORENSEN, & STRINGA, M, (2008) "The integrated impact of credit and interest rate risk on banks: an economic value and capital adequacy perspective", Working Paper no. 339, January 2008, Bank of England. FAINI, R, (2005) Fiscal policy and interest rates in Europe. Universit di Roma Tor Vergata, CEPR, IZA, and CSLA GROSSMANN, A, & JACKSON, D, (2005) The Impact of FOMC and ECB Interest Rate Announcements on European ADRs and their Underlying stocks: Which Matters More University of Texas - Pan American GUZMAN, M, (2006) The Impact of Paying Interest on Reserves in the Presence of Government Deficit Financing 2Department of Economics, University of Reading. HOUSE OF LORDS (2006) The Current State of Monetary Policy, Report of the Select Committee on Economic Affairs December 2006. HSO. LEWIS, C, (2006) UK interest rates increased and further hikes possible, London's Economy Today, Issue 48, August 2006 Greater London Authority (GLA). MARTIN, C, & MILAS, C, (2005) Uncertainty and Monetary Policy Rules in the United States Keele, Economics Research Papers, KERP 2005/10, The Keele Economics Department, University of Keele. NICKELL, S, (2005) "Practical Issues in UK Monetary Policy, 2000-2005" Keynes Lecture in Economics, Read 20 September 2005, at the British Academy, The British Academy. The Mortgage Guide United Kingdom. http://www.mortgageguideuk.co.uk/interestrates/risinginterest.html WARNOCK, F, A, & WARNOCK, V, C, (2005) International Capital Flows and U.S. Interest Rates, Board of Governors of the Federal Reserve System, International Finance Discussion Papers, Number 840, (September 20 2005). Read More