Are Higher Global Interest Rates a Thing of the Past?
Floyd, David, Management Services
Of late, interest rates globally have been at historic lows in many countries. The USA, UK and Europe have experienced rates of under five per cent for nearly a decade, however there may be some small rises in the future.
This article sets out to explore why this may be the case and whether it is likely to continue in the future. The article draws on economic data both from USA and Europe as well as international sources and theories from the Economics discipline in order to provide an explanation for current global trends in interest rates and inflation.
Introduction to the main causes of inflation and higher interest rates Theoretical Explanations
There are many economic explanations for why interest rates may need to rise. Increases in prices and the rate of inflation often lead to interest rate rises. Inflation can result from increasing supply costs. Supply costs may rise due to increases in wages. In the UK for example, wage inflation has been kept low due to reform of trade union power and both in Europe and USA trade union membership has also declined. In addition the UK government has limited growth in public sector pay to two per cent over the next few years.
However there can still be inflationary pressure arising when there is little unemployment and skill shortage, as the USA is experiencing since unemployment there has recently gone under the five per cent level. Bootle1 2005 suggests that inflation may now be dead due to pay constraint being seen as acceptable by most workers. There have however, been higher wage claims for company executives though these represent only a small proportion of the total workforce.
There are also other causes of inflation besides wage increases. Costs on the supply side can also rise if for example, there is an increase in the price of raw materials, according to Sloman2 2005. The recent increase in the price of oil by 50 per cent for USA citizens led to small increases in interest rates from one to almost five per cent in 2005. However this has been less substantial than during the 1970s oil crisis and better contingency plans have been put in place. There have also been concerns over gas prices.
Price rises may also occur if interest rates are too low and there is a lot of cheap money available. People are more likely to borrow , demand and spend more money during these times. Friedman3 suggests that inflation may therefore occur when there is too much money chasing too few goods. The quantity theory of money states that changes in the nominal money supply lead to equivalent changes in the price level. The theory is very much defended by monetarists today. However the theory should be taken with care, since there are cases of countries having high increases in nominal money but experiencing lower prices, see table 1 and the case of Japan over a 30 year period 1962 - 1992. Real variables adjust for changes in the general level of prices whereas nominal variables refer to values at the prices ruling when the variable was measured. Some of the reasons for higher prices in the UK compared with Japan for example, could be a result of expectations of price rises arising from the vast amount of financial deregulation that was taking place.
The quantity theory of money has other limitations for the monetarists, as it states that MV=PT, (money times velocity of circulation equals the price times the number of transactions). However it is very difficult to measure money in the economy. Narrow measures such as MO which includes notes and coins may miss out important variables. On the other hand a broader measure such as M4 may prove difficulty in calculating all the components that are necessary to be included. Finally governments have had trouble in the past trying to restrict bank lending, often banks have found a way round regulation introduced by government.
However it is still important for government to ensure the money supply does not expand too rapidly. …