The Curse of Low Interest Rates

The Bank of England's Monetary Committee was this week split but Interest Rates have again been held at record low levels of just 0.5%. Surely this is good news for us all and the economic recovery?

The reality is that there is a ticking bomb in the system as those people who either are already on standard variable rate (SVR) mortgages or are due to be on them soon, have a nasty shock in store. The fact is that interest rates will rise - it's just a matter of when not if. SVR today is from 3.5% to 4.95% and many people have budgeted the affordability of their mortgage and lifestyle based on this rate. If base interest rates should raise by just 1%, then it would constitute as much as a 29%% rise in SVR and, therefore, repayments which is a huge increase. And let's face it, given past SVR levels, a 1% rise is trivial.

The saviour for people in this predicament in the past was to grab a fixed rate mortgage around now and lock themselves down on repayments. But the problem is that new fixed rate offers are factoring in what banks think will happen to interest rates and in many instances these deals are unaffordable already for people on SVR. There is a ticking bomb in terms of potential repossessions in the future.

The indicators in the economy are not good. The retail sector is suffering as 4%+ inflation rates hit. Jane Norman, Thorntons, TJ Hughes, Carpet Right, Habitat amongst others have suffered terminally in a raft retail of bad news. And only part of this can blame the internet changing buying habits or out of town shopping growth. You can tell when it gets tough when affluent London commuter towns like St Albans have boarded up shops in the High Street and Poundworld is the most thriving shop. Consumers are already reining in their credit exposure and spending. The news gets worse as only yesterday British Gas spoke of yet another hike in gas prices of around 20% as a strong possibility and we already are seeing upward pressure on food costs.

The fact is that inflation figures are misleading. The real inflation rate amongst people with average or lower disposable incomes is actually much higher as those goods which are increasing in price faster represent a higher proportion of average spend to these people as it may do to richer people. The rising cost of energy hits average incomes much harder than higher incomes as these people may spend the same on energy but it is less of a proportion of their average spend than lower paid people.

And today, Public Sector workers are striking over austerity measures which threaten their pensions which are gold plated compared to the real world of the Private Sector. But here's another reality. The Government does not invest lump sums over the long term 'saving and investing' to pay for Public Sector pensions, they actually come out of the current account paid for by National Insurance. So Public Sector pensions are paid directly out of our taxes, there is no magic fund or annuity to pay this. You and I, everyone, pays for Public Sector pensions directly in our tax bills today - and this is only going to get higher. So while in the Private Sector we have a crisis looming in terms of retirement income, we are paying for the gold plated, premium Public Sector pensions in our tax.

And the Public Sector workers think we will support their strike? They must be joking.

So people stuck on SVR mortgages have it in all directions - higher interest repayments to come, more taxes to pay for Public Sector pensions and the like and higher inflation on staple goods. It's not a pretty place to be. Add in greater uncertainty on jobs, particularly in the banking and retail sectors and the picture is very gloomy.

In many respects, the damage caused by the economic disasters in the financial sector has yet to really bite. The next 24 months could see some very tough times and a band of people are right in the firing line. By keeping the interest rates low to kick start the housing market, many people who got new mortgages based their affordability assumptions based on lower interest rates continuing.

This is the curse of low interest rates.

Icy Reception

Iceland has agreed to pay a sum equivalent to 40% of its GDP as compensation for the money lost by Dutch and British savers in the collapse of online bank Icesave.

Icelandic voters are up in arms, seeing this as taxpayers coughing up for the mistakes of businessmen, to the tune of almost €12,000 per person in a country of only 320,000 people. In terms of lost opportunity, the interest on the payments alone would run the cost of their entire health system for six months.

Icesave attracted savers and Local Authorities alike through its marginally higher interest rates but when it collapsed it was not covered by the FSA compensation schemes - something that savers had ignored in order to get at the extra savings interest. One could argue convincingly that the apparent lack of care by the FSA and the savers allowed this to happen while taxpayers in Iceland can rightly say that they should not be liable for compensation for the mistakes of a small group of greedy businessmen who happily risked the deposits on crazy products as a result.

In Britain, even before the banking collapse, saver deposits were protected to a certain extent and the Government moved in quickly to support all deposits, following Ireland's lead. The FSA has always had such a scheme - but why should it support the deposits of foreign savers? And should Iceland have a similar scheme?

Perhaps more importantly was the question of why several local authorities, including my own, were depositing funds in such saving schemes when they knew they were not protected by the FSA? It seems that not a single person in Local Authorities lost their jobs for not checking this and many such staff in charge of the management of funds do not even have formal accountancy qualification. Yet, such mistakes have to be funded by private citizens who pay tax in Iceland.

The Icelanders are not taking it lying down. A large petition has been put together and around 56,000 or 23% of Iceland's voters have signed it to try and prevent the payouts. If only the British voters could have been bothered to do the same perhaps we would have saved paying out such massive blank cheques to save the careers and fuel the wealth of a tiny percentage of this nation's citizens or at least made sure there were enough caveats to make them all culpable should it ever happen again.

But that's the stoic Brits for you. £1.3 trillion bail out to save rich bankers? Why not.

Enterperise Biz-Tsar

It's good to know that our Enterprise Tsar, Lord Sugar, is there batting for all us small businessmen in his role to advise the Government on such matters that affect us.

His professional and positive approach was to explete vehemently with his back to the camera when asked, at an Exhibition on How To Survive a Recession, what did he advise for businesses in the recession. He then came back to the camera, visibly upset, to say we should stop talking about a recession as there is not one. Despite the fact his own Government's figures tell us that, in fact, we are still in one.

During his speech in Cambridge he was critical of small businessmen who 'whinged' and implored they should get on and 'adapt'.

While his bull faced staring down of the recession is a positive and bold attitude, calling small businessmen whingers in the face of their pleas to be heard by the Government was not exactly what people wanted to hear - except those who could afford to be at the exhibition. Once again, it is worth reminding ourselves, Lord Sugar and the Government that small businesses represent 97% of all the companies in Britain and employ 13m people, paying a disproportionate amount of tax into the coffers via Corporation and PAYE tax. In the scheme of the vast stimulus packages wasted on the financial system, the amount of credit to such businesses has been reduced by nearly £15bn this year. It is not even a small crumb of comfort that interest rates have been again pegged at 0.5% and QE has been increased by £25bn when most of that aid does not flow into the economy at large.

It would help if an Enterprise Tsar stopped representing his own views and values and understand how this recession is affecting small businesses, many of whom will not survive this year and have contributed disproportionally to the rising figure on unemployment.

To take just one example from the weekend's papers. Small, independent shop owners have gone to the wall at an alarming rate this year while huge supermarkets announce growing profits and sales - over 500,000 have lost their jobs in that sector alone and some 12,000 businesses have failed. Tesco, Waitrose and even Marks & Spencer, meanwhile, have thrived.

Perhaps Lord Sugar should down into the detail and look at which businesses have been favoured in the stimulus strategy. No doubt, companies like Viglen, which he owns, have benefited nicely from increased Government spend in the schools sector.

For a man who is normally well at ease when he has plenty of script to work with in front of the cameras, he was pretty poor when asked about his supposed specialist subject ad hoc.

QE(D)

There's a lot of debate as to whether Quantitative Easing (QE) is actually working. The Bank of England recently agreed to increase its use of QE and will spend as much £175bn on the program.

The problem is that down at the street level, the amount of lending is falling short as banks have missed their lending targets, repeatedly. In fact, the desired effects of QE which should be a good deal more credit being offered into the market in terms of new loans, mortgages and the like have been sadly lacking. In fact, there are plenty of accusations that financial institutions are ripping off consumers and business as the cost of business loans and mortgages are several percentage points above the base interest rate of 0.5% which has remained the same for 5 months. In theory, we should have had a bonanza in new credit in the market - the effect has been pretty much the opposite.

However, banks tell us that the reason why loans appear very expensive compared to the base rate is that they have to borrow money to lend on the wholesale money markets where interest rate is a good deal higher, so their profit margins on the apparently high interest rate loans to consumers and business are not as high as we think. This does indicate that QE has not had a great deal of effect. I go back to what QE was supposed to do.

In the past, I have likened QE to champagne glasses stacked three tiers high so that there is one on the top, two on the second tier and three at the bottom. If you pour champagne into the top glass it fills and overflows and starts to fill the two glasses in tier two which subsequently fill and then overflow into the bottom tier. If you imagine that the Bank of England holds the champagne bottle and the champagne is the money they are pouring into the financial system then we see it cascade down from the institutions to banks to the public. That's the basic principle.

But what is happening, or at least there is good evidence of it in the accounts of banks, is that banks have a target to get their loans-to-deposit ratios back in order as this was a huge problem for banks like RBS. QE is the process of buying Government gilts and if we assume that most of that new money flows to banks then it is effectively 'new deposits' of the safest kind in the banks. This means that if the banks hold onto the cash then their ratios look a damn site better. If they want to make more loans, then they could get money in off the wholesale markets and theoretically this will not dilute their loans to deposit ratios too much.

It is in fact as if instead of champagne glasses in tier two of our champagne glass pyramid but two buckets which take a long, long time to fill when they are being filled by the overflow of a single glass before they overflow and cascade into the glasses below. Until the banks feel their ratios are in order, then they are not likely to offer a great deal of this new money out in terms of credit - or that's one explanation. It is probable that they would even lend this money out to other banks anyway as that is far safer lending than to the public or business anyway with all these guarantees flying around.

In a daft twist, some of the money raised by institutions in gilt sales may have also been lent to banks in the form of short-term debt securities which means that banks are getting a nice level of subsidised lending from the Government in two forms as all such debt is underwritten. Again, there is little incentive to lend this money out to less safe hands.

Finally, it seems that as the FSA has instructed banks to buy more safe debt like gilts, much of the cash flowing into the banks from QE is actually going to buy gilts again. This helps the banks' liquidity ratio by stacking up on more 'quality' liquid reserves. It provides a great killing if you sell gilts but doesn't do the economy a great deal of good - in fact, as I blogged recently, it seems that new paper money is buying a great deal of our own new debt. I am no genius, but that has to be unhealthy in the long term as you cannot keep buying high value goods with new paper money. I would like to be disproved on that as it feels like a time-bomb to me.

On the face of it, QE seems to have just pumped money into banks who have sat on the cash. It is the reason why Chancellor Alistair Darling gets so cobby with banks when they consistently miss their lending targets which was the PM's and his (along with those clever investment banks advisers) grand plan to rescue the economy. I dare say we are actually better off because of it but there is a real danger that we either put too much in and trigger rampant inflation or we put too little and we get the opposite effect. It is why QE has never been a generally sensible way of controlling an economy as Japan and Argentina found out. It's why the Bank of England has adopted this measure only for the first time in its history.

Because unlike a QED (Quad Erat Demonstratum) proof of a theory, QE is not an exact science at all. It is pure guesswork.