Living in a low inflation era

FOR months most people have assumed that the next move in interest rates will be upward. Now, attention is turning to - and stock markets are reflecting - the possibility that rates might fall further.

That is a remarkable prospect. UK base rate at 4% is at a 38-year low. The US Federal Funds rate is just 1.75%, The European Central Bank's rate is 3.25%.

It is in the US that the chance of even lower rates is greatest. Many expect the Fed to cut to 1.5% or below next Tuesday. Goldman Sachs thinks we could eventually see 1%.

What is going on? It is only ten years since UK base rates were well into double figures. Are we entering an age of deflation? Are we condemned to repeat the experience of Japan - a decade of ultralow interest rates and economic paralysis?

It is true that 1% rates, if we see them, will not be a sign of health. They will signal rather that the US authorities are spooked by the threat of a 'double dip' recession. The IMF is set to cut its forecast for US growth in 2002 to 2.2%. But the Federal Reserve is vowing to learn from Japan's mistakes. In a lengthy paper on the Japanese experience this summer it concluded that if Japan had cut rates faster at the outset, it might have avoided its downward spiral. The Fed is determined to be different.

There are encouraging signs that cheap money is already having an effect in the US. Friends Ivory & Sime economist Steven Andrew points out that car sales are soaring. If American consumers respond to the tonic, their economy will recover and drag the rest of us along in its wake. Wall Street's rebound on Tuesday reflects that hope.

The UK consumer needs little prompting. Retail sales have slowed from the heady 6% growth in spring, but are probably still rising at close to 4%.

That makes it less likely and less necessary that UK rates should fall. If US borrowing costs really hit the floor, Andrew can see the UK coming down to 3.5% and euroland (now at 3.25%) to 2.75%. Europe has the most sluggish economy of the lot, but its response to cuts is also sluggish, since the conservative Continentals borrow less than we do.

On balance, it is unlikely that interest rates will head for zero. More probably, they will stay low, possibly into next year. That still requires a hefty adjustment for most of us. Borrowers need to remember that, if UK rates eventually rise to 5%, their mortgage repayments will soar by one quarter.

Savers need to lock in to good interest rates when they can. These days, anything over 5% (such as Leeds & Holbeck's 5.55% fixed rate) is becoming as rare as hen's teeth.

Investors must wonder why low inflation and interest rates, which in theory should support asset prices, have been good for the house market but not the stock market. But houses, unlike equities, are in short supply.

Equities will recover when companies clean up their accounts and have credible expectations of raising profits. Returns may be lower than in the boom years, but in a low inflation era gains of 7% or 8% will still look attractive. Some top companies are now returning 5% on dividends alone.

We can live with low inflation. It is a dive into deflation that would be the real worry.

Taxing times

BEWARE of taxmen talking reforms. There are promising ideas in the consultation document on Reform of Corporation Tax. But problems are already looming.

Company tax certainly needs updating. The paper sensibly proposes to end the 'schedular system' and bring different types of income into the same tax pool. More tendentious is the idea that 'capital gains should be taxed in the same way as income' and that 'increases in the value of an asset' should be 'part of taxable capacity'.

Tax should apply only to realised capital gains. Otherwise, firms could be taxed if their offices rise in value. This would be like taxing householders on the rising value of their homes - dynamite.

Gordon Brown appears sincere in his wish to modernise. He has helped business by cutting corporation tax from 33% to 30%. But small firms have been loaded down with red tape.

Using the tax system for social engineering causes unexpected side effects. Attempts to ease taxes for small firms are laudable. But Grant Thornton's tax partner Mike Warburton recently explained how nannies can save large sums in tax by forming companies. This is the nanny state gone mad!

Warburton says the reforms will work only if the Chancellor listens carefully to critics. That sounds right.