"Uninteresting Rates"

Can we just settle this once and for all so that we can all move on from this rather uninteresting debate about interest rates - the Federal Reserve won't get any further than 4.75% and everybody else in the West will be constrained by that.

The reason why the US is capped at 4.75% is that interest rate policy is run for job creation. No doubt in his first days in the job Federal Reserve Chairman-elect, Ben Bernanke will be taken aside by a mysterious official, led into a darkened antechamber and shown the following graph. Even to those uninitiated in the Masonic economics of the most powerful economy in the world, it doesn't take too much looking around to find the jobs/interest rate relationship and the proof of it (see first chart). It should be clear to the casual observer that the Federal Reserve only really started cutting interest rates when jobs were being destroyed. They then kept on cutting them as things deteriorated then held the Federal Funds rate at 1% until there were clear signs that job creation had started again. Imagine how many years at university could be saved if everybody knew that this is how things are really run in the US and therefore in the world.

Thank goodness that the markets agree with this idea. A casual look at the interest rate markets shows that they have come to pretty much the same conclusion as the employment model. Interest rates are set to peak in mid-year at around 4.75% and after that we enter the next phase of the interest rate cycle. The UK in the meantime is also on hold while (extraordinarily) Europe is set to raise interest rates along with (more plausibly) Japan.

Leaving aside these movements, there are a couple of things of note. First of all this seems about right and as such this is probably the best signalled interest rate cycle we have seen in decades. On that basis alone, we really should stop agonising about interest rate movements of central banks because they really are very uninteresting. The next action they could be expected to take of any real note won't be until 2007 when interest rates should start coming down again.

The other thing to note is how terribly boring these movements are. Those of you with a long enough memory, or weren't at school a the time, will remember with some nostalgia the days when, for instance, UK Chancellor Nigel Lawson used to jag interest rates up and down one percent at a time (or more) on what felt like on a monthly basis back in the 1980s. Without wishing to sound like an old war horse pining after the good old days, going to work each day felt somewhat crucial as you never really knew what could happen.

Nowadays there is much less excitement and there are good reasons for it. First of all, the economic cycle has become just that much more predictable and more to the point, less volatile. Things hum along at a rather benign rate which leaves most central bankers largely untroubled as they retire in their night cap and gown. Just to add to the situation, at the same time, the volatility of inflation has declined considerably making the job just that little bit more easy, if it needed to be made any easier, that is (see US example in the second chart).

With inflation rates low, stable and below long-term averages while growth meanders between ok and rather good, it looks like we have to get used to something that wasn't really taught in the universities of the 1980s - the deflationary boom.

Growth is usually synonymous with inflation in the minds of many economists because this is what they were taught in lectures at their alma mater. Unfortunately, economics is one of the great intellectual failures of the 20 th century as it lags what is really happening in the world. Economists tend to spend about twenty years understanding what happened in the previous twenty years and by the time they have understood that, the world has moved on and all they are left with is trying to cram the world into what they understand rather than understanding what is happening today 1 .

For this reason alone, the deflationary boom is probably one of the most important ideas that investors will hear for a very long time. We have actually written about this on a number of occasions before, but in essence we should get used to the idea that western economies can grow because they are no longer saddled with the costly process of actually making anything as all production is now subcontracted out to people who like to do it, do it well and, what's more, at a very low cost. Western economies earn their way in the world by becoming the administrative centres of what Charles Gave and his colleagues at GaveKal Research describes as the "produce nowhere, but sell everywhere 2 " holding companies that uses people, their minds and computers to manage resources and create wealth. All of these things are cheap and because of it the simplistic econometric equation;

falls to pieces and with it the activity of central banks.

Just looking around you, you have to have some sympathy with this idea. Here in the UK, for instance, the high street is being decimated by the internet as people leave the shopping experience behind. Because of this, our own Bank of England has thrown in the towel recently and admitted that the Office of National Statistics isn't really able to provide the data it needs to manage the economy. Many of the things that are happening on a daily basis aren't captured by traditional measures of economic theory any more.

While emerging economies are doing just that - emerging - the prospect that they will export inflation will stay a remote possibility. We may come back and say something different in, say, five years' time but, in the meantime, don't expect any kind of radical action by western central banks. This interest rate cycle is over.