Economic View: We've got less money and we have to get saving: something has to give and that's the retail therapy

So rates are up again and may well hit 6 per cent. Add this to increased taxes and unbalanced finances, and it's time to tighten our belts
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The Independent Online

Don't say you weren't warned. No one can be sure of calling interest rates right but I still think, as I did last autumn, that anyone seeking to borrow a large sum for a mortgage should be aware that rates may rise to 6 per cent. Indeed, I now think this is inevitable and people should be prepared for the possibility of even higher rates than that.

The reason has something to do with inflationary pressures of course. True, the headline figures have come back a little. We will get the July figures next week and maybe there are some nasties there. Meanwhile, the June ones showed the consumer price index at 2.5 per cent, still above its central value, and, more alarmingly, the familiar retail price index at 4.3 per cent. The RPI is the one used to calculate pensions, index-linked gilts and so on.

Even if inflation has come back a little, rates allowing for inflation are still not that high. If you take the RPI as the reference point, base rates of 5.75 per cent are not high at all: a real interest rate of less than 1.5 per cent. That is a bit misleading because an increase in the cost of borrowing designed to cool inflation has the perverse effect of boosting the headline RPI. Perhaps the best measure is the RPI minus mortgage interest payments. That was at 3.3 per cent in June, giving a real interest rate of just under 2.5 per cent. On historic performance, that is about average.

But the need for higher rates is not just to do with inflation. It is also about cooling the housing market, with house prices the highest they have been in relation to income for at least a century. It also has something to do with the surge in money supply, building up inflationary pressures for the future. And it has something to do with the over-expansionary fiscal policy, with the Government borrowing too much for this stage of the economic cycle.

If, however, I were to pick out the one recent statistic I find most disturbing it is the fact that we are saving less now than for a generation or more. Rates have to be higher to persuade people to save more.

The left-hand graph (from Capital Economics) tells the story. In the first quarter of this year, household savings were just 2.1 per cent - down from 3.9 per cent in the final quarter. We can be pretty sure this is not sustainable and at some stage people will rebuild their savings. Interest rates are not the only way of inducing people to borrow less and save more, but they are the main way of doing so - crude but eventually effective.

So why are savings so low? I think the simplest answer comes in two parts. Part one is that people feel free to borrow, particularly against the security of their homes, which on average will have risen by 10 per cent in value in the past year. Part two is that their real incomes are being squeezed and they want to maintain their standard of living.

The right-hand chart shows what has been happening to real incomes - ie incomes after inflation. They have been falling for the past six months. Prices, including mortgage payments, are going up faster than wages. On an annual basis, real incomes are up a touch, but that was due to rises in real wages last year.

The reason for the squeeze? A combination of tax increases and higher rates. Both are likely to go on squeezing real incomes for at least a year, probably two. On the Government's own figures, the tax burden rises this year and next, while the markets are projecting 6 per cent base rates by the autumn and rates at that level right through next year.

If, in the face of this squeeze on real incomes, we are also going to increase our savings, there is only one place the resources can come from: lower consumption. I am afraid we will have to tighten our belts.

This will happen despite strong economic growth of around 3 per cent this year. That does seem likely to continue, for the latest figures for industrial production, out on Friday, show it gathering pace. That is encouraging in one sense, of course, for it suggests that industry is coping with higher rates and the two-dollar pound. But a squeeze on consumption is not much fun for the rest of us.

The issue is whether we can get away with lower growth in consumption or face actual declines. A bit depends on how quickly the adjustment takes place; an adjustment over two years would be much tougher than one over five. A bit depends on what happens to energy and raw material prices. If they come back down a bit, it takes lot of pressure off family budgets. Taxes matter too: were they to stop rising, that would be a huge help.

And, finally, a lot depends on how high savings need to be. If they are to go back to their long-term average of nearly 8 per cent of household income, that would suggest five years of increases in consumption of only some 1.5 per cent a year, compared with the 4 per cent or so we have experienced over the past decade.

In the long term, savings have to be much higher, if only for demographic reasons. But that adjustment is 10 or more years off. Meanwhile, we have a three- or four-year problem. Provided overall growth remains strong, it is all perfectly bearable. If growth falters, well, things are less bright.

That is another subject for another day. But it is fascinating to see more and more economists talking and writing about the next global recession. A new paper by Goldman Sachs came out last week, the gist of which was that we were all right for the next year or so. I think that is right. What worries me is that UK finances, both national and personal, are not in as good a shape as they were ahead of the last global slowdown, as those savings figures show.