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Friday, November 28, 2003

Interest rates up in the long run? Think again

The talk grows louder by the day: The economy is recovering, and that means higher interest rates are on the way.

But, in fact, long-term interest rates have already risen in anticipation of the recovery. Here in Singapore the two-year inter-bank interest rate has jumped 1 percentage point since June to more than 2 per cent. Short-term interest rates will tend to follow later. This is the reason why banks are busy nudging up their home mortgage rates for the fixed-rate packages.

Nonetheless, economists and bankers say short-term interest rates in Singapore will rise only gradually at first. DBS Bank, for example, expects the three-month inter-bank interest rate to head towards 2 per cent only by the end of next year.

All agree that local interest rates will take the cue from the United States. Financial markets are betting the US Federal Reserve will start to raise short-term interest rates from May next year, possibly pushing the Fed Funds rate up to 2 to 2.5 per cent by the end of next year from the current rate of 1 per cent.

I believe the Federal Reserve would like to be in a position to raise the Fed Funds rate to 5 per cent, in due course, so that it has sufficient room to lower interest rates to fight the next recession.

But will the Fed be able to? I have my doubts. In 12 months, interest rates could start softening again. This admittedly is not a popular view at the moment because there are many indicators suggesting interest rates could go higher.

Start with rising commodity prices. As Bloomberg reported, the price of soya beans used to make animal feed and cooking oil surged 45 per cent in the past four months. And it's not just soya beans. The Commodity Research Bureau's industrial spot price index is up 38 per cent in the past two years.

Adding fuel to the fire is a world 'awash in liquidity'. At least that's how Dr Edward Yardeni, chief strategist of Prudential Equity Group, described it. And didn't Nobel Laureate Milton Friedman once tell us that inflation is 'everywhere a monetary phenomenon'?

One measure of global liquidity is the non-gold international reserves held by central banks. By this measure, global liquidity is growing at a rate of 18 per cent, the fastest in about seven years.

With commodity prices on the rise and global liquidity greasing the wheels of commerce, you may justifiably argue that inflation is only a matter of time. And you could be right.

But, there's one crease in this neat argument. Over the years, all that extraordinary growth in 'liquidity' has not led to exceptional money creation in the banking system of a growing number of countries.

That's a curiosity.

Let me explain. International reserves at a central bank accumulate partly because of the country's trade surpluses. When the exporter brings his US dollar earnings home and deposits these with his bank, he can spark off an outsized effect on credit creation.

This is because banks need only set aside a fraction of the credit they extend as reserves. So any increase in deposits in the banking system should set off a multiplying effect on loan growth.

However, if you look at Japan, this has not happened. While foreign reserves are growing at a rate of over 30 per cent, money supply is up just 1.3 per cent. And this is not a recent phenomenon: Japan's foreign reserves grew some 70 per cent in the past three years, but money supply grew a paltry 5 per cent.

In Singapore, the same phenomenon: Foreign reserves are rising at a rate of 14 per cent, compared with 3.5 per cent growth in money supply.

So while commercial banks' ability to create money has increased, they are not exercising this option: either because their customers are not keen to borrow, or the banks themselves are hesitant to lend.

Whether this situation will change could depend on how far businesses regain pricing power. For if they can't do so adequately even as the cost of raw materials rises, then deflationary pressures will return.

The industrialised economies would then be in for a squeeze. The release last week of October's US producer prices didn't suggest any improvement in the ability of manufacturers to pass on higher cost. While there was a 14 per cent jump in the cost of crude materials - less food and energy - the price of finished goods rose just 0.4 per cent.

Wal-Mart's chief executive officer Lee Scott says US consumers remain cautious, 'timing their expenditures around the receipt of their paycheque, indicating liquidity issues'.

So Wal-Mart, the world's biggest retailer with sales of merchandise worth US$244 billion (S$417 billion), kicked off a price war earlier than usual this holiday season. Prices of 15 popular toys were 12 per cent lower than those of Toys R Us. Some of Wal-Mart's toys are reportedly below wholesale prices.

In Singapore, Ms Noor Aziza Rafeek, 44, says she has halved prices of her baju kurung at the Hari Raya bazaar in Geylang Serai, but sales are slow. Ms Noor is a 13-year veteran at the bazaar and claims to make at least 30 per cent profit in the past. This year, she is hoping just to break even.

So can the irresistible force of rising 'liquidity' bring back inflation and higher interest rates? It could just find itself huffing and puffing against an immovable object.

Eddie Lee is Senior Economics Writer on the Straits Times

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