Hamish McRae: The UK is set to lead the way today with action to tackle global financial warming

Liquidity will eventually be absorbed or, if property prices decline, be destroyed
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The Independent Online

The world is still awash with money but gradually the taps are being turned off - or at least tightened, as we shall see today here in Britain. It is such an odds-on bet that interest rates will rise that the only open issue is the small chance that the Bank of England might increase rates by half a percentage point rather than a quarter.

This is a British story, of course, and we go into the argument behind the need for higher rates in a moment. But it is also an international story, or rather I think it is important to see what we are having to do within the international context of the need to rein in excess liquidity worldwide. The problem is not just us. In terms of the causes of the explosion of global liquidity we barely register. But we do very much see the impact of this in, most obviously, our prime property. Why are parts of London the most expensive residential areas in the world? Answer: because some of that money washing round Russia, the Middle East and East Asia has to find a home somewhere.

As far as our own situation is concerned, it has become increasingly evident that the series of increases in interest rates have failed. Their aim was twofold. First, they were to check inflation; second, to curb the housing market. (Officially it was only the former, in practice the latter mattered a lot too.)

The Bank of England's Monetary Policy Committee will have a good sniff of the April inflation numbers, to be published next week. But even if the consumer price index has come back below its 3 per cent ceiling, it will be clear that the previous targeted measure of inflationary pressures, the retail price index minus mortgage interest payments, is still above its 3.5 per cent ceiling. As for the housing market, well, it may have slackened a little, but prices still seem to be rising at double-digit rates.

Why have previous increases failed? I think it is partly the fault of the switch from the old RPI less mortgage rates to the harmonised European inflation calculation, renamed the consumer price index. We apparently had to do this because we have to harmonise out calculations with Europe, but the new CPI is a less satisfactory measure. It excludes housing costs, which seems to me a bit stupid. Had we stuck to the old measure, the warning bells would have rung several months earlier.

But it is not only that. The other part of the problem is that the Bank has focused too much on this flawed measure of inflation and not paid enough attention to wider inflationary pressures, in particular what has been happening to money supply. To his credit, the Governor now acknowledges this. The links between money supply and inflation are very elastic and change over time. It was right to abandon these as the principal guide to policy in the 1990s. But they give a useful second indicator of widespread inflationary tendencies.

The first graph shows what has been happening to one crucial element of broad money, M4 lending. Don't worry about the arcane aspects of the monetary aggregates; just look at the picture. A lot of borrowing is going on, and that is showing up in the money supply numbers. The next graph shows one of the areas of borrowing, the amount of money borrowed for buying homes. That hit a new all-time high in March of £19.3bn. GFC Economics, which provided these graphs, reckons that new loan approvals will be the key indicator that will determine whether a further increase in rates is needed after today.

Part of the reason for this surge is the rise in the individual size of each new mortgage. In March that was £174,200, compared with £140,000 a year earlier, as the third graph shows.

The Bank should not accept the blame for this increase in the size of mortgages, for that is the decision of the banks and building societies making the loans. But it is clear that the old rules of lending people not more than three times their income have been blown to pieces.

At any rate, the total net lending to the personal sector in the UK is running at close to the record it reached in 2003 (final graph), and of course this rise is cumulative. Even if the rate of new net lending comes down, there is still the great wodge of money borrowed in the past that has to be serviced. This loadsamoney era has the counterpart of loadsadebt too.

So that is our contribution to global financial warming. But as I said, in world terms we are not that significant. Much bigger contributions have come from the US, from the Middle East, from Russia and East Asia. The excessive liquidity in the States is gradually being worked off. House prices there are, in many areas at least, now falling. Consumption growth has eased off, though it has not gone negative.

On the other hand, while energy prices remain so strong, both the Middle East and Russia will continue to accumulate huge surpluses, all of which cannot realistically be invested locally. So the flood of money from there will continue. The Chinese share market has been the best-performing one in the world over the past three months, gulp. As for India, well, did you know that India has now become the second largest inward investor in London?

I have been looking at some data showing the increases in stock markets over the past three months. Korea and South Africa are both up 12 per cent; a clutch of continental markets (Sweden, Germany, the Netherlands) are up 8 per cent. Mexico, Brazil and Australia are only just behind. We here think of the UK market being strong, but it is in global terms very much a middling performer. The Bank Credit Analyst team that has been following this phenomenon notes that the fastest-rising markets over the past year have also been the fastest-rising over the past three: so momentum continues to be the dominant theme. It also believes that "abundant liquidity and decent valuations should help to drive share prices higher over a 6-12 month period with many of the current leaders continuing to outperform".

In this climate, it is very important to remember that liquidity will eventually be absorbed, or even, if property and other asset prices decline, be destroyed. Gradually global monetary conditions will tighten, as what is happening here will happen elsewhere. But this will take a long time. The UK is, with the US, simply an early mover in what will become a global trend. Meanwhile, be aware that a lot of us think that this rise in UK rates will not be the last one, and that a few of us, myself included, still think that UK rates may well reach 6 per cent this cycle.

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