Magical misdirection

Whilst we have all become preoccupied by the ''will they/won't they'' fine reading of central bankers' words, we appear to have missed the point. It really doesn't matter if the US Federal Reserve inserts another syllable into their monthly meeting statement, or if Monsieur Trichet at the ECB says the word ''inflation'' in his latest utterance slightly louder than the last one, or for that matter whether our own central bank governor Mervyn King fails to wear his spectacles in his latest speech. All these things are the equivalent of a magician's sleight of hand, aimed at deflecting you from the real trick. Central bankers, at least in the West, are not in charge of global interest rate policy and they are certainly not in charge of the interest rates that control the economy.

Arguably, the central banks that will squeeze inflation out of Western domestic economies are those in the emerging markets; and a jolly good job they are doing of it. I've lost count of the number of emerging markets that have increased interest rates in the past few weeks whilst our 'big three' have been confined to the sidelines, ''talking tough'' on inflation. It's all they have left really.

Meanwhile, the real job of restraining the economy is being achieved through the free markets. No matter how much we concentrate on base rates or government bond yields, the interest rates that really control the markets, as we see it, are swap rates. Amongst other things, these are the rates at which banks borrow money over terms like two and four years (or more) and determine what kind of mortgage deals are offered. This is crucial to economies, not only because of the prospects for further lending, but also because the resetting of prior two- and four-year mortgage deals is an ongoing process that is determined by market swap rates.

Take a look at the first chart and what you will notice is that, whilst central banks have been on hold over the past three months, swap rates have been rising from a trough in the first quarter of this year.

Indeed, in the case of the UK and Europe, swap rates, (the interest rates felt most keenly by the real economy) are now higher than they were last June before the banking crisis hit, even though the Bank of England, for instance, has cut base rates by 0.75% since then. This is the equivalent of a significant monetary tightening within the real economy. So anyone expecting any kind of relief from central banks in relation to their debt payments is looking in the wrong place. If anything, the rise in swap rates combined with the indirect growth tax from higher energy and food costs is going to crush the Western economies going forwards and cause widespread deflation in discretionary goods and services.

An appeal to the banking sector then would be more appropriate than looking towards Mervyn King and his kind to help out with the situation. But this seems somewhat futile and forlorn because the banks are neither inclined nor able to help. Obviously, this is related to their capital positions. It is not a coincidence that, as bank shares have fallen (see second chart over page), swap rates have risen. Capital has become a scarce commodity that is needed to shore up balance sheets and that is reluctantly lent at penalty rates. Anecdotally, and in the press, the UK is awash with stories of UK residents seeing their mortgage payments increase by 50 - 80% in the blink of an eye. Going forwards, this is going to have long-range effects on the UK in particular which will last for several years.

Although we have become fixated with the oil price as the single issue to worry about, it's a sideshow compared to the re-fixing of mortgage rates in the future. The UK bond market yield curve in particular remains very inverted (long rates being lower than short rates), but this is not a sustainable situation going forwards. Through the natural attrition of the economy and the deflationary consequences of energy costs, we see market and base rates falling in the future, causing a reshaping of the UK yield curve.