Hamish McRae: Fed keeps rates down but fears a sudden surge in bond yields

The penny has dropped in the US. We have known for some time that the Federal Reserve no longer had any freedom to drop interest rates further. Now it is becoming clear that it will have to hold rates low for a long time.

This has profound implications for the developed world, including Britain. We have seen the limits of central bank power. Our own Bank of England is acutely aware of the dangers of any loss of authority, as its reaction to the new inflation target shows. But this is a global story, not just a UK one.

For several years the Federal Reserve has appeared all-powerful. True, its chairman, Alan Greenspan, has been criticised for allowing the share-bubble to be created in the final years of the last century, and has more recently been attacked for allowing a bond bubble to grow. But, in general, he has been praised for driving down short-term interest rates and helping the US to come through this recession in better shape than previous ones. Or so it seems.

But all policies have costs, and the cost seems to be a slower recovery than after any recession, at least since the Second World War. Worse, long-term interest rates have risen sharply, so sharply that this week the Fed was forced (or at least encouraged) to say that it would hold interest rates steady "for a considerable period" even if growth picks up further.

It is fairly clear that the Fed has been shaken by the bounce in bond yields since the spring: the 10-year rate rose from 3.2 per cent to about 4.4 per cent before steadying. There have been similar increases in other countries, as shown by the average for the Group of Seven 10-year yields in the first graph. Rates look set to move higher still, or at least that is what the market is predicting. The implied rise from money market rates is also shown on the graph.

The principal fear of the Fed ­ and all central banks ­ is that there might be a rerun of 1994, when yields surged. You can see what happened in the US, UK and the countries now in the eurozone in the other graphs.

Were this to happen again, the most obvious casualty would be the US housing market, which has been supported by people re-mortgaging their homes at lower rates and thereby increasing their real income. The US transmission mechanism from cheaper home loans to increases in demand is different from that in the UK. More than half the UK mortgage debt is tied directly to short-term rates, so that any change in rates has a direct impact on households within a couple of months.

In the US, most home loans are for fixed rates. However, people can easily re-mortgage if long-term rates come down, which has been happening to an enormous extent. Families could cut their monthly mortgage bill by negotiating a new loan and paying off the old one.

But now, suddenly, that avenue has been closed, or rather made much less attractive. If long-term rates continue to rise, people will no longer be able to cut their cost of borrowing. New home-buyers will still be able to borrow at an attractive rate. But the mechanism for making the monthly accounts more pleasant to look at, cutting the cost of finance, will no longer be open.

So in this respect, the US is different from the UK. Over-simplifying a bit: low short-term rates here hold down mortgage costs; in the US they only do so though their influence on long-term ones.

What happens next is hugely important, and there are two completely different views.

One, the minority view, is that this recent rise in rates is just a blip on a long downward path that has still some way to run. The model here is Japan, where 10-year yields, which had been as high as 8 per cent in the early Eighties, dipped to just 0.8 per cent in 1998. This is not to say that US rates could fall as low. This would only happen if deflation takes hold in the US in a similar way to Japan, and this is unlikely for a number of reasons. But it is perfectly possible that the fall to 3.2 per cent could be repeated, and that bottom breached if the US does show signs of deflation.

The majority view, on the other hand, is that 3.2 per cent was the bottom. Government borrowing, an albeit slowly recovering economy, the natural growth of the US, and the determination of the Fed to hold short-term rates low even if this means rekindling some inflation ­ all this will combine to cause a gradual rise in long-term rates.

There is an obvious investment conclusion: the time may have come to go back to equities, which offer reasonable value and some protection against inflation.

But what is the conclusion for the UK? Here the rise in long-term rates has taken place in a much less aggressive way. One of the main reasons for this is that pension funds have to some extent been forced by the minimum funding requirement to buy gilts. Now that these regulations are being altered there will be some switch back, a switch estimated by the Treasury to be £5bn.

The view of UBS in the City is that this might be a gross underestimate, a view to which many would concur. If big money were to move out of gilts into equities you would expect gilt yields to rise. Add in the overrun on the deficit this year and presumably next. Quite suddenly we could see our own long rates surging too. That, at least, is the concern of the Bank of England implicit in the new Inflation Report.

Perhaps the best way to look at the changing relationship between the central banks, the Government, the financial markets and the investment community is to keep one very simple idea in mind.

This is the law of supply and demand. We have been coming through easy times. Inflation has been falling and some governments have been in surplus. So we are used to a time when the power has been on the side of the borrower.

Now things will change. Over the next five years there will be a massive supply of government bonds. Budget deficits will average around 3 per cent, which in the case of Europe and Japan will be faster than the growth rate.

Investors will gradually exert their power, forcing up rates as much as they can. Governments will use every device that they can to hold down borrowing costs. If inflation remains low and they are confident that this will continue, they will issue index-linked bonds. They will try to nudge central banking institutions to hold down short-term rates and maybe finance themselves more at the shorter end.

Investors will resent this. Central banks will fight to retain their authority and their independence. But governments will need independent banks to continue to persuade investors to lend on reasonable terms.

So it is all going to be much tougher. The majority view above is probably right, and May was the bottom of this interest rate cycle and of a longer-term 25-year downward trend. Since the late Seventies central banks have painfully re-established monetary discipline. They have reaped the rewards in reputation; governments have reaped the rewards in cheap money. That is fine; but now there are new challenges.