Prudent firms, says David Smith, will protect themselves against rises in interest rates.
The story so far this year in the world's financial markets can be summarised in just five words: fear of higher interest rates. Ever since early February, when the Federal Reserve Board, the US central bank, signalled the start of a gradual tightening of monetary policy (that is, rising interest rates), the markets have been unable to think of much else.
No matter that America's economic cycle is out of kilter with Europe, which is struggling to shake off recession, or Japan, which is very much mired in it, Britain has an economic recovery - but even its best friends would concede that it is fragile.
True, there are special reasons why higher US interest rates should have a disproportionate impact on the markets. Where America leads, others, eventually, will have to follow. The Federal Reserve's move was a reminder that interest rates can go up as well as down. And the particular importance of US mutual funds, which had been heavily invested in overseas markets, meant that an American interest rate move was always likely to be amplified in its impact.
Surely, however, worries about interest rates in Britain are overdone? We are in a low-inflation environment in which many of the things that have led to high interest rates in the past - strong growth in money and credit, high wage settlements, a boom in consumer spending and sharply rising house prices - no longer exist. This, certainly, has been my view. Even forecasters who are bearish on the outlook for UK interest rates, such as the National Institute for Economic and Social Research and the London Business School, only expect the gentlest of rises, to give a 6% base rate during 1995.
But could things turn out to be much worse than this, justifying the concern of the markets? I have been looking at history. With the exception of 'Black' Wednesday, 16 September 1992, when the Bank of England lifted the minimum lending rate from 10 to 15% in the course of a few hours in a vain attempt to keep the pound within its ERM limits, we have grown accustomed to very small interest rate changes, and usually in a downward direction (16 September does not count, because the changes were immediately reversed, once sterling had succumbed to the pressure of the currency markets).
Think back, however, to the last time we saw a sustained rise in interest rates. At the end of May 1988, base rates were at a 10-year low of 7.5%. It was, coming after the big tax-cutting Budget of March 1988, all systems go for the economy. By November 1988, however, base rates had been increased, in a series of steps, to 13%. Less than a year later, in early October 1989, they were even higher, at 15% (where they were to remain for a year). In the space of just over 16 months, the level of interest rates doubled.
Oh well, you may say, 1988-9 was an unusual time, an isolated example of a government getting things badly wrong by allowing the economy to overheat, and belatedly correcting matters. Or was it? History is of very little comfort when it comes to looking at interest rates in Britain. At the end of November 1984, base rates stood at 9.5%. A couple of months later, at end-January 1985, they had jumped to 14%. In early April 1978, we were in what appeared to be another benign period for borrowing costs. Base rates were only 6.5%. Again, it did not last. A year and a half later, base rates were up at 17%, and the economy was thrust into deep gloom. Also in the 1970s, but a little earlier, rates rose from 7% in early December 1972, to 13% a year later.
Sudden interest rate changes, far from being unusual, appear to be rather typical. Surely, however, these moves reflected conditions that will not be replicated in the foreseeable future? Up to a point. The 1972-3 period, like that in the late 1980s, reflected conditions of runaway boom (economic growth in 1973 exceeded 7%, easily a post-war record). In the late 1970s, higher interest rates were partly the result of a change of government, with Margaret Thatcher's newly elected 1979 administration determined to take an axe to inflation.
The 1984-5 move was somewhat different. The economy was not growing rapidly. Inflation was not a serious problem. Interest rates rose sharply for one reason: to support a weak pound (in early 1985 sterling came within a whisker of one-to-one parity with the dollar). The weakness of sterling was also a secondary reason for the sharp rise in rates in the late 1980s (see graph, p19). Nigel Lawson, as Chancellor, wanted to raise rates for domestic economic reasons. But he was forced to go further than justified on domestic grounds because of a falling pound.
This, I think, represents the main risk of our present benign interest rate environment. The Treasury, supported and monitored by the Bank of England, wants to maintain low inflation. The aim is for underlying inflation (the retail prices index excluding mortgage interest payments) to stay within a 1-4% official target range and to be within the lower half of that range by 1996-7. Both Treasury and Bank have made clear that a substantial fall in the exchange rate would endanger that ambition very significantly.
It is not difficult to think of an environment in which the pound would be sold heavily by currency dealers. It could come from a deepening of the Government's political problems, perhaps triggered by a very poor showing in the spring local elections and the June European elections. It could arise from a reassessment of Britain's financial position - if, for example, the Bank of England encounters problems in selling enough gilt-edged stock to fund what will continue to be a very large public sector borrowing requirement. Or the markets could take fright if the trade gap starts to widen as recovery sucks in imports. Alternatively, a perception that the recovery is stalling, because of the impact of the April tax increases, would be equally damaging.
The prospect of a sharp rise in interest rates does not, as I say, represent my central view. The Government, I suspect, will move heaven and earth to prevent rates from rising sharply. Sterling, and therefore the UK interest rate outlook, will benefit from an unexpected reduction in interest rates by the German Bundesbank, and hence by other European economies. The domestic environment, one of weak growth and subdued inflationary pressures, will represent a powerful counter-weight to exchange rate driven pressure for higher interest rates. After all, the Treasury and the Bank of England can point to the post-September 1992 experience, when the pound fell sharply without rekindling inflation in Britain.
The fact remains, however, that when interest rates rise they often do so rapidly. There has to be a possibility that history will repeat itself. In which case, the message is clear. Companies should take advantage of the low interest rates we have at present. But they should also protect themselves, where possible, against unwelcome increases in rates. Home-buyers are already doing this, hence the boom in fixed-interest-rate mortgages. Prudent companies, I would expect, are taking equivalent action.
David Smith is economics editor of the Sunday Times.