Hamish McRae: Rates will rise for prudential reasons

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The Independent Online

The financial markets expect the Bank of England to increase rates today to 4.25 per cent. The markets don't always get their way - they were wrong-footed last month - but the balance of probability is very much that this time they will. While the official inflation target is being undershot, there are sufficient concerns about inflation in the pipeline to give the Bank's monetary committee the excuse to increase rates, if that is what it feels is most prudent to do.

If this is right, what will it mean for the future profile of interest rates and the economy more generally?

Stand back a moment and look at world rates. The UK is a little unusual in that we are leading the upward swing. The Fed chairman, Alan Greenspan, hinted this week that US short rates will start to move up this summer. The European Central Bank looks like being on hold but is now thought unlikely to cut rates and may start to increase them next year if the eurozone shows decent growth. But seen globally it is pretty clear that rates are on the up.

The top left-hand graph, from brokers Williams de Broë, shows what has happened to real long-term rates and real short-term ones on a global scale since 1965 and with some projections to 2009.

A couple of points. First, negative real interest rates are very rare. We have them at the moment at the short end because both dollar and euro short-term rates are below inflation in the US and (by a smaller margin) in the eurozone. UK real short-term rates, at around 2 per cent, are more normal. Over the past 40 years short-term global rates have fluctuated between 6 and -2 per cent but real interest rates tend to stabilise around the 2 per cent mark, and the projections forward therefore seem pretty sensible.

Second, with the exception of the dreadful 1970s when the central banks lost control of inflation, long-term real rates have settled at about 1 per cent higher than short rates - a real rate of around 3 per cent. Again, the forecasts seem credible, the differences being that real long-term rates now are already more normal and that, again with the exception of the 1970s, long rates are more stable than short.

The key point that emerges from this long view is that the UK has normal interest rates, and both the US and the eurozone are in an unsustainable position. The US has rates that are too low because of the determination of the Fed to keep the US economy moving at all costs, while the ECB has rates that are too low because of the need to counteract the sluggish performance of the big eurozone economies. Arguably our rates may be a touch low but they are not especially so, at least by historical standards.

So why the pressure to increase UK rates at all? You can make a bit of an argument on grounds of inflation that may or may not be in the pipeline. Unemployment is low, though as yet there is little pressure in the labour market. That could change were it to fall even lower.

More worrying is the extent to which our present lack of inflation is dependent on a strong currency and falling import prices of goods. Globally there does seem to be mounting inflationary pressure, seen in the commodity markets and in the oil price. And arguably there is excess demand at home, a result of a borrowing boom.

That leads to what I believe is the real reason why the Bank is likely to increase rates today. It will be increasing them for prudential reasons, not monetary ones. That is not in the monetary committee's remit - it is supposed to worry about only inflation - but it is a legitimate concern of any central bank. You don't, if you are central bank, want people to borrow more than they can afford because you don't want the instability that will result from people or companies going bust.

The bottom left-hand graph gives a historical view of the extent to which British households might be over-borrowed. As interest rates have fallen, people have taken on more debt. That is normal and rational: people know how much they can afford in monthly repayments and if rates go down they feel they can borrow more. But even allowing for the fall in rates, people may have over-cooked things. The calculation, done by Roger Bootle for Deloittes, shows what will happen if interest rates rise to 5 per cent by the end of next year.

The bottom line is all interest payments. As you can see it kicks up quite a bit but nothing like the way it climbed at the end of the 1980s, the last credit crunch. But look at the top line. If you allow for repayments of debt, for example on a mortgage, the running cost of servicing debt relative to income is pushing towards the 1990 peak.

Or at least it may be if debt levels keep on rising. If this argument that the real worry of the Bank is a prudential, not a monetary, one, then it must hope that modest increases in rates now will change people's behaviour. The greater attention we pay to its concerns now, the less we are likely to be punished later.

Arguably the Bank is responsible for our excessive willingness to borrow. Merrill Lynch has measured whether monetary policy is restrictive, expansionary or neutral by looking at how much nominal GDP is expected to rise and current base rates. For example, if real GDP is expected to rise by 3 per cent and inflation is 2 per cent, that would be an increase in nominal GDP of 5 per cent. So as a rough and ready indicator of policy stance, you could say that rates below 5 per cent were expansionary, rates of 5 per cent were neutral, and rates higher than that were restrictive. The result is shown in the top right-hand graph.

Apply this and you can see that the Bank was correctly leaning against the boom in the late 1990s and has been leaning against the world recession since then. But at some stage it will have to switch. When?

The bottom right-hand graph shows another indicator - also from Merrill Lynch - of the risks of rate rises. Here, the brokers have taken the probability that the monetary committee attributes to GDP growth being above 2 per cent in two years' time, plus the probability it gives to retail price inflation being above 2.5 per cent (the old target) and dividing by two, pushed forward six months. As you can see this risk indicator worked very well from 1998 to 2002 as a signal for what would happen to base rates. It has not worked since then but it does give some feeling for the pressure the monetary committee is under, on its own assumptions, to increase rates.

Merrill Lynch does not suggest rates will go back to 7 per cent or anything like that. But it does forecast a peak of 5.25 per cent a year from now and it believes the risks are on the upside.

Practical conclusion? Expect higher rates, of course. Pencil in 5 per cent base rates in the course of next year. And if you're planning to borrow big, just make sure you could still service your debts if rates went to 5.5 per cent. And if you are borrowing on a credit card, pay that back fast.