Is the world’s banker about to stumble?

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Inflation may be about to undo the reputation of Alan Greenspan as the safest pair of hand’s steering the US economy (and read that as the world’s economy).

Tuesday, July 13th 2004, 9:25PM

by Jeff Matthews

The chairman of the Federal Reserve has lifted US interest rates from a 46 year low at 1% to a still modest 1.25%.

He’s also signaled further increases. The question is will they be large enough and in time to stop inflation getting out of control?

The doubts amongst economic commentators are growing.

Inflation in the United States in the first five months of the year reached 5.9% on an annualised basis, three times the 1.9% of 2003.

High oil prices are partly to blame though the Federal Reserve like the Reserve Bank of New Zealand tends to look through the initial shock to the longer affects. More fundamental to the inflation story are the large US budget and trade deficits.

Till interest rates rise above inflation there’s an incentive for people to borrow to invest pushing up the price of assets like houses as they do so.

Only when interest rates turn positive – by rising above inflation- is inflation likely to be tamed. Alan Greenspan has only to look back to the 1970s and the 1980s to see what happens if inflation is unleashed and the pain his predecessor Paul Volcker had to inflict to bring the US economy back to health.

It’s easy to forget that at the start of 2001, before the September 11th tragedy the Fed rate in the United States was 6.5%.

New Zealand’s Reserve Bank is already heading that way with economists predicting a further quarter of per cent rise in the official cash rate to 6% at the end of the month.

And with the economic growth barely slowing, further moves up are likely.

So what is the practical advice for the times?

If you are a borrower, higher interest rates raise the cost of debt and therefore the total you pay in dollars to service it. If you can’t, or don’t want to, carry a heavier load, there are at least two ways of lightening it:

• Reduce the amount you owe… by using any uncommitted cash, or perhaps the proceeds from selling an asset
• Restructure the debt to a longer timeframe, reducing the principal component of your repayments.

Think carefully before adopting the latter strategy, as longer payback periods increase the amount of interest paid over the total period of the loan.

For depositors, a rise in interest rates can be a benefit, but there are two things to take into account:

• If the rise is linked to a movement upwards in inflation the benefit is largely illusionary. Your real return is calculated after inflation – ie. if the interest rate is 6 percent and inflation is 2%, the calculation might be 6 – 2 (income tax) – 2 (inflation) = 2%. Don’t be in a rush to spend the extra money
• If you are convinced that interest rates could rise further than they already have, it might be sensible to stay liquid – ie. keep with short-term deposits so you can lock in higher rates later. (Naturally, the reverse is true in a downward trend.)

Investors in other assets – say, shares or property – could see the values influenced by any significant movement in interest rates.

As a generalisation, shares tend to fall in value when interest rates rise significantly.

The same is true of property. Given that investment property is generally highly debt-funded, rising interest rates increase the cost of ownership, lowering the return. This will generally lead to a fall in prices as new investors will pay a lower price to achieve the same level of return.

Many analysts are concerned that current high debt levels make the property market more vulnerable to interest rate rises. As for a share portfolio, the least risky strategy will generally be to hold for the long term, taking the anxiety about short-term interest rate movements out of the picture.

Higher interest rates also impact on government and corporate bonds. Prices move inversely to the interest rate. The regular interest payment to the holder of the bond (the coupon) is a fixed amount, and the price adjusts as interest rates change. So a rise in interest rates means a decline in the value of these assets. That implies caution about buying them at such a time, unless your strategy is to hold for the long term, accepting the coupon and not worrying about short-term value changes.

Long term investors should not become overly concerned about short-term movements provided debt can be managed without the forced sale of assets. Inevitably, that issue tends to arise when asset prices are at their lowest.

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