Friday, 11 March 2005


The Malta Independent - Friday Wisdom

Federal Reserve Chairman Alan Greenspan last month described the phenomenon of long-term interest rates failing to respond to persistent increases in short-term interest rates as a conundrum – a puzzle he was finding difficulty to understand.

How could the markets trading in long-term treasuries ignore the persistent rises in short-term interest rates, which went up in several gradual measured steps from one per cent in June last year to 2.5 per cent by January 2005? How could fixed mortgage rates for long-term house loans fall when short-term interest rates were going up sharply?

Since he spoke the markets have started taking note of Mr Greenspan’s concern and long term interest have indeed started to respond. However, this was also in reply to subtle signals from Asian Central Banks which expressed an interest in diversifying their monumental holdings of foreign reserves from their over-concentration in US dollars, mostly US treasuries. The signals are that unless the markets respond with higher interest rates in order to keep in check the tendency of the US dollar to fall on the foreign exchange markets since operators are concerned by the sustainability of huge US balance of payments deficit, their willingness to continue buying US treasuries could be called into question.

While central banks have direct influence on short-term interest rates, at the long end of the curve, interest rates are market-driven and central banks can at best exert moral pressure to move interest rates in the direction and up to the level they consider desirable.

Participants in US long-term treasuries have been caught up between mixed signals. The determination of the Federal Reserve to continue rising short term interest rates in order to remove the excessive monetary accommodation extended to the economy between January 2001 and June 2003 (in order to cushion the shock from the tech bubble aftermath and the political instability caused by terrorist attacks on US home ground and the Iraq war) could not but have pressure to move up long term interest rates as well.

On the other hand, the markets noted that there was no pressure resulting on the inflation front at retail price level or at investment asset price level (real estate and equity markets) – as a result, these questioned the need for long term interest rates to rise to account for a non-existent inflation threat.

On the contrary, some long-term treasury participants considered rises in the short-term interest curve as an important measure to pre-empt the development of inflationary pressures so that the threat of rising inflation in the long term need not be accounted for by rising long-term rates.

Personally, I have always found these arguments unconvincing and tend to lean to the view that an economy growing at four per cent per annum could only sustain 10 year rates at four per cent by exposing itself unduly to the risk of developing underlying pressures on inflation at asset price level if not at retail level, which would have to be addressed by higher future interest rates if timely precautionary measures are not taken.

With this in mind, I have been in favour of reducing exposure to US fixed income securities at the long end of the interest rate curve with the exception of High Yield and Emergent Economies securities which have equity like features and are less sensitive to interest rate rises than investment grade bonds. However, now that the margin on such High Yield and Emergent Economies securities has narrowed so much that rising interest rates could reduce their attraction at such narrow margins. Moreover, it probably is time to reduce exposure thereto as well.

The same, however, does not apply to euro fixed income securities where the risk of rising interest rates on the euro is being pushed further into the future as the US dollar fall on foreign exchange markets puts pressure on the competitiveness of euro area producers who depend on exports for their growth which is in any case less than half of the growth being experienced in the US. The European Central Bank would be failing its “growth” duty if it were to consider rises in euro interest rates before the euro exchange rates normalise against the USD from its current over-valuation, something which is not quite in sight unless there is a sharp rise in US interest rates.

Where does this leave our own monetary policy? Since December 2002, the Central Bank has reduced the benchmark rate from four per cent to the current three per cent and has kept interest rates steady at this low level since June 2003. In the press releases justifying its interest rates decision, the Central Bank regularly refers to the need to restructure the Maltese economy to make it more globally competitive and its strong believe that monetary and exchange rate policy have no role to play in such restructuring except in providing stability.

The mission of the Central Bank is indeed “to maintain price stability and to ensure a sound financial system, thereby contributing to sustainable economic growth”. Its principle objective is to implement monetary policy decisions “designed to influence aggregate demand in the economy contributing to the creation of a stable environment that is conducive to sustainable and balanced long-term economic growth”.

Do we have a local conundrum here? Are the Central Bank monetary policy decisions effectively leading to the desired stability and growth at a time when we are clearly losing our international competitiveness and have an unquestionable asset price inflation – fuelled by the low interest environment – in our real estate and capital assets equity market?

Maybe it is good to ponder these issues in the silence of pre-election day.

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