Hamish McRae: The global squeeze on monetary conditions may not be over quickly

So, the next rise in UK interest rates to 5.75 per cent is certain, and it is very much odds-on that they will go to 6 per cent, maybe more, before the end of the year. We know this from the tone of the minutes of the Bank's monetary committee and, in particular, the narrow margin of the rejection of another rise last month. My own view at the time was that they had made a mistake not to go up. That view is shared by four of the members, including the Governor.

We need to figure out what a world of 6 per cent interest rates will be like. What will be the direct consequences on, most obviously, the housing market, but also on investment, economic growth and inflation expectations? We also need to think beyond the UK because this gradual monetary squeeze that the Bank is imposing is merely one element of a global shift towards dearer money: the end of a period of excess liquidity. Small point: yesterday the Swedish central bank increased interest rates there. No country is an island, not even the US.

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I think the first thing to be clear about is that this is something that will last two or three years. There will be two or three years, maybe a bit longer, of real interest rates around the world being quite strongly positive. Translated to the UK, that will mean 3 per cent real rates: if inflation on the retail price index, adjusted to exclude mortgage rates, stays about 3 per cent, we will have 6 per cent base rates. If it goes higher, we will have higher rates. When it comes down to 2 per cent, then rates can come down.

Why do I say the RPIX and not the CPI? Because it is a better measure of inflation - it was the one the Bank used before it was obliged to switch to the common European measure, which does not include housing costs. No one really trusts the CPI because it does not square with their own experiences, but even the CPI on a long view looks alarming. As you can see from the first graph, it has come back a bit but is still very high by the standards of the past decade.

Why positive real interest rates of 3 per cent? On a very long view you would expect positive short rates of, perhaps, 2 per cent, but because we have had a long period when rates were below that, there will have to be a period when they are a bit higher to claw back some of the excess money swishing around the system.

To give you some feeling for that, take what has been happening to UK money supply. Annual broad money supply growth rose to 13.8 per cent in May, up from 13.3 per cent in April and 12.8 per cent in March. So if growth was 3 per cent in real terms, that is an excess of more than 10 per cent of money which is trying to find a home.

It is hardly surprising that some of this money goes into house prices. The link between money supply and inflation is a loose one, which was why monetary targets were replaced in the early 1990s by inflation targets as the main guide to policy. But real growth of 3 per cent and monetary growth of 13 per cent suggests an excess of 10 per cent. So how much have house prices gone up in the past year? As you can see from the next graph: 10 per cent.

Unfortunately, it is not nearly as simple as that, for there are many other influences, including international capital flows, and there are many other assets into which the money can be put. But the basic point stands that at the present level of interest rates the UK banking system creates excess liquidity. That has to go somewhere, and one of those places is the housing market. Maybe there has been some tailing-off of price pressures, but sales expectations, particularly in London, are still strong, as you can see from the next graph.

So the economy will have to live with higher rates for some time. The consequences of that will be some slow down. That may already be happening, at least in the labour market, for total employment is shrinking (final graph) as the public sector is no longer able to increase its hiring. That does not mean there will be a huge unemployment problem, for the labour market remains strong. It is just not quite as strong as it was a few months ago. Sure, that will hold down inflationary pressures from higher wages, but higher wages are not the problem. The problem is higher fuel prices, higher commodity prices, higher world food prices, maybe higher world manufactured good prices - and higher world asset prices.

All these are global phenomena, about which we can do nothing. We cannot slow the rise in Chinese wages any more than we can slow the rise in Chinese carbon emissions. But we have to deal with the consequences, and the sooner we grab the bits of the problem that are within our scope to tackle, the more manageable they will be.

This period we have entered, of a gradual move towards tighter money worldwide, will be shaped by two main factors. One will be what happens to world interest rates, the other, what happens to world savings. As argued above, there will have to be a period of positive world interest rates to compensate for past laxity. We have moved some way towards this in the UK but, in world terms, what will matter more will be what happens in Europe and the US. I think present expectations in both monetary zones are too low, but the issue is at least out in the open. The world's bond markets remain on the case, after a rough couple of weeks when they signalled alarm.

What will happen to world savings, I find harder to fathom. At the moment, something like three-quarters of the new net savings in the world come from Asia, Russia and the Middle East. That finances the US deficit and, indeed, the UK one. At some stage, Chinese consumers will want to enjoy more of the fruits of their own labour, and Japanese demography will cut its savings too. The oil producers will be unable to spend their flow of funds entirely at home, particularly if that flow continues to grow, but they will try to spend more and more of it in the region.

So, at some stage, this glut of Asian savings will be absorbed, just as the glut of petrodollars was absorbed in the 1970s and 1980s. Lower global savings will, other things being equal, mean higher global interest rates. What I suspect is that once the monetary squeeze is taking effect in a year or two, falling Asian savings will reinforce its impact. Then it will be necessary for the developed world's central banks to bring rates down again. But the sequence and timing of all this is impossible to judge.

All that can sensibly be said is that we should not assume the global squeeze on monetary conditions will be over quickly. We could, here in Britain, be in for a couple of years of rates at, close to, or more than, 6 per cent. And the world could have five years or more of strongly positive real interest rates. This is not a disaster; it is simply a natural outcome of a period when, initially, rates were too low and, subsequently, global savings too high.