Tuesday, 15 December 2009

Credit ratings, interest rates and the price signal

The BBC's economics correspondent, Stephanie Flanders, has noticed that the bond market is treating UK gilts as if they were AA-rated rather than AAA-rated. Which begs the question, if they were officially AA rather than AAA, how would the markets treat them?

I suppose the whole question is about the effect of credit ratings on the bond market. Quite clearly here, the credit rating is wrong, or the agencies know more than the market (which probably isn't true). And once again, the many individual agents have done a better job than an agency.

Which brings me to interest rates. Just like a credit rating, the interest rate acts as a price signal (though more so in the latter case) - and if it's wrong, naturally, a bubble is created. 2002-2007? Possibly, since it's widely believed that interest rates were too low and therefore money was underpriced - excess demand to delve into economic theory. I digress.

So it's a distortion of the market. At least with credit ratings, bond markets can act pretty much independently; there's no agency with a central price like the Bank of England with its interest rates. But this is quite interesting.
Additionally, there was upward pressure from housing, mainly from mortgage interest payments which rose this year but fell a year ago.
I'm probably jumping to conclusions, but the market sees a rise in the demand for credit, and so is pushing up the cost of lending? So it does have some influence after all?

So I tend to agree with this piece I saw in the Times back in July. Prices should be set by demand and supply, demand and supply are best set by the voluntary actions of individuals, the money market has demand and supply (even if it is a means of exchange, rather than a good/service), so interest rates should also be set by the voluntary actions of individuals - no central agency or committee can ever know the details of every single transaction.

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