Low interest rates usually fuel recovery. Higher interest rates check booms. We are now approaching the anniversary of much lower rates in the UK and US. Sure enough, on cue, first the surveys then the output figures start to show improvement from the lows of the first half of 2009. It is what you would expect.
There are two complications in this cycle. The first is the extremes which the monetary authorities have placed on markets. Markets were kept remarkably tight, short of money a year ago. Now there is unprecedented money creation in an effort to ease things more rapidly. This would point to a stronger and faster recovery, if all things were equal, from the severe slump the monetary tightening understandably produced.
The second is the state of the banks. Because many large banks entered the downturn in weak shape, with poor levels of capital and cash, they will not be able to lend on as much as normal as more money is created. Indeed, this problem has been augmented by the decision of banking regulators to demand more cash and capital at this stage of the cycle, reinforcing the problems the banks have in growing their lending.
Those who mainly see the first problem expect further rises in share prices, as the easy money finds its way into assets. They also expect a V shaped recovery. Those who are more preoccupied by the second problem fear a U shaped recovery, or even a double dip recession or a prolonged L shape, with little positive growth.
It is not yet clear how the balance of forces between easy money and broken banks will work out. It does seem likely, however, that a heavily indebted country like the UK will struggle more than better placed countries and more than in the recent past to sustain a lively pace of growth.
A few months ago it was fashionable to expect deflation. Prices in many countries started to fall. The extreme monetary tightness and the collapse in activity suggested a long period of price falls. More recently some have queried this outlook, especially for the UK where price rises have continued as measured by the CPI across the worst period of recession. The weakness of sterling last year led to imported inflation. The government sector has continued to put up fees, charges and petrol tax. Some companies have decided to hold or increase prices despite poor demand, arguing that they will not gain volume anyway so they may as well recoup a bit more cost from price.
The Monetary Policy Committee of the Bank of England concentrates on the alleged output gap. They reason that the economy is producing well below its capacity, so they think price increases will stay under very good control. They should worry a bit more. More companies might decide to recoup on price what they cannot gain on volume. More capacity may be destroyed more rapidly, as companies seek to reduce cost and create more pricing power. Commodity prices have already shot up from the lows, despite low world output, as speculators and the Chinese have stockpiled more in anticipation of higher demand.
Easy money is here for a bit longer. This is generally good for asset prices. The banks remain damaged, which is bad for growth. The large public deficits in the US and UK need to be addressed at some point. Interest rates cannot remain this low indefinitely, especially where governments need to borrow large sums of money. We remain happier with Asian equity than with UK.