Economic View: We should all expect higher interest rates, but we can leave the fears of disaster to the market professionals

The jitters of the 'masters of the universe' may cause many people to lose a lot of money, but we are not yet facing an economic crisis
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The Independent Online

The real tug of war has begun. In the past few days, two important things have happened in financial markets that pull in opposite directions.

One is that in both Britain and Europe, interest rate expectations have hardened. Here we have had an Inflation Report from the Bank of England and a signal from the European Central Bank, both of which suggest higher rates this autumn.

The other is the fallout in the markets. The sub-prime crash in the US has led to one of the blue funks that financial markets periodically suffer, when no one is prepared to make a price on significant assets and markets just jam up. Every few years, the "masters of the universe" suddenly get scared. None of their carefully constructed models work and they don't know what to do. So they do nothing and quite a lot of people lose quite a lot of money.

A common reaction to this is that it could not happen to nicer people and we should just let them stew. Unfortunately, the long history of financial panics has taught us that the costs of doing nothing are much more than the costs of intervening by supplying cash to the markets to tide them over. The magic words are "systemic risk". The world's central banks have a responsibility for controlling inflation but they also have a more general responsibility for maintaining financial stability. If there is a risk of a collapse of the financial system, they have to intervene. The costs of not doing so swiftly and effectively? Well, something like the Great Depression of the 1930s.

Both these themes, higher interest rates and market discontinuity, have been rumbling away throughout this year. Indeed it has been the gradual tightening of credit worldwide, following several years of exceptionally low interest rates, that led to these ructions. We all knew that something like this would happen: the only surprise is the timing and the extent of the damage.

So what happens next? I don't think it is possible to say much that is helpful about the fallout in the markets in the coming weeks. The thing has to play its way out. But as the news comes in of another hedge fund going under, or whatever, it is important to bear in mind two things. One is that world growth is strong and most companies in most countries are doing well. The other is that world share prices, when calibrated against company earnings, are not terribly out of line with historical experience. And they are cheaper now than they were a week ago. We are, at the moment, facing a financial scare, not a more fundamental economic one.

There is, however, more to be said about UK inflation and interest rates. The Inflation Report looks at the Bank's expectation for inflation based on market expectations of interest rates. Inflation is expected to converge on the 2 per cent central point that the Bank is supposed to aim at. Only the more extreme possibilities go above 3 per cent or below 1 per cent, the outer bands of acceptability.

That is based on market expectations of rates, not present rates. These are derived from money market rates. Three months ago, they thought rates would be around 5.6 per cent through most of next year. Now they think they will be around 6 per cent.

The way the Bank calculates risks is complicated; the conclusion is not. The markets think there is about as big a possibility of rates going above 7 per cent as there is them falling below 5 per cent. How about that?

I suppose the reaction of most people would be that 7 per cent would be – for many homebuyers at least – pretty dreadful, while 5 per cent would be normal. My own reaction is that we should not rule out the possibility of 7 per cent rates, even though I don't think it is likely. If, conversely, there were a grave global financial crash, then I would expect UK rates to fall back below 5 per cent. But no one wants that either.

The balance of probability, it seems to me, is that UK rates will stay around 6 per cent for the next 18 months. I don't think it matters much whether the next quarter point comes this month or next. It is just possible (though unlikely) that we are already at the peak at 5.75 per cent. As people's fixed-rate periods end, they will have to remortgage at higher rates, in some cases significantly higher. What matters is not the quarter per cent either way but the medium-term trend. Here (again barring a grave global crash) I think we are heading into a period of two, three or maybe more years of fairly high interest rates. That will happen worldwide but may be particularly marked in Britain for several reasons.

These include the extent to which our costs have been held down by large-scale inward migration, and our prices have been held down by an increase in imports from lower-cost countries. Taken together, these have given us something of a following wind. Now there are signs that the pace of inward migration will ease slightly and, more alarmingly, global pressures on the price of traded goods (including food) are rising.

We also have a current account deficit now nudging 3 per cent of GDP, against one of around 2 per cent of GDP for most of the past decade. Add to that what is arguably the most overvalued major housing market in the world and it is not hard to make the case that the UK will continue to need to have higher interest rates than most other developed countries.

This is not a disaster by any means. Indeed, it is in some ways simply a response to solid and sustained economic growth – but it is something we all need to be aware of at a personal level. Let's leave the disaster side to the professionals in the markets for a bit.