Hamish McRae: We don't know which figures to believe but there's no hiding from a rate rise when it hits

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The Independent Online

Rule one: when in doubt, do nowt. Rule two: when the statistics are all over the place, trust your instinct.

Rule one: when in doubt, do nowt. Rule two: when the statistics are all over the place, trust your instinct.

It is impossible not to be fuddled by the stats that have been emerging about the British economy in recent weeks, yet today the Bank of England's Monetary Policy Committee has to try to figure out what to do about interest rates. Officially the economy has not grown for six months but retail sales are booming. Officially inflation is below the target of 2.5 per cent, yet house prices are rising at something like 18 per cent. Given these doubts, unless the Bank knows something that the rest of us don't, expect it to do nothing.

If that is right, and we will know at noon today, the interest rate issue is settled for another month. But the puzzle will not go away. The game of trying to judge what will happen both to interest rates and to the economy will run on through the autumn. To try to understand the nature of these uncertainties, consider first what seems to be happening to the economy; then what is happening to that crucial determinant of demand, house prices; and finally, what might happen to sterling.

The economy first. We are all accustomed to think in real terms. When we say that the economy has grown by, say, 3 per cent and inflation happens to be 2 per cent, in terms of money the economy will have grown by 5 per cent. But we are so used to inflation that we automatically knock that off our calculation of the real economy.

Most of the time this works well enough. We may not get the inflation calculation exactly right but it won't be terribly wrong. Now, however, this is not working very well. In some parts of the economy the age of inflation is over. Many goods are actually falling in price, whereas most services are rising by much more than the retail price index. So the rate of inflation varies enormously depending on how you do the sums.

You can catch a feeling for part of this confusion by looking at the top graph. This shows nominal (ie money) GDP, then real GDP using what is generally considered to the most accurate measure of inflation, the GDP deflator. It also shows what happens to real GDP if you use instead the retail price index to adjust for inflation.

As you can see nominal GDP has ticked away steadily for the past decade, rising at around 5 to 6 per cent. But inflation, on both measures, was even higher at the beginning of the 1990s and so real output declined – we were in recession. Then as inflation fell through the 1990s the lines move together. But now look at what seems to be happening at the beginning of this year. The top line, money GDP, has carried on growing at nearly 5 per cent. But if you adjust with the conventional measure of inflation, the GDP deflator, output is indeed pretty stagnant. According to that measure there seems to have been a surge in inflation. If on the other hand you adjust with the RPI, output is still growing by around 2 per cent.

So why does one measure, the GDP deflator, say that inflation is rising at an annual rate of something like 5 per cent, while the other, the RPI, says that it is closer to 2 per cent?

The best explanation I have seen comes from Capital Economics, an independent economic consultancy. It argues that the RPI has been held down by cheap imports, while the deflator has been pushed up by the rising price of exports, in particular of oil. That would figure, particularly since in addition to the oil price, the strongish sterling will have forced exporters up market, thereby enabling them to charge more for their goods.

If oil is the main reason for the discrepancy this would suggest that we should believe the stagnation implied by the GDP deflator because oil will eventually fall in price. If on the other hand we have generally lifted our game as exporters, then maybe there was some real growth.

The truth is, unfortunately, that we simply do not know for sure what figures to believe. What we can see pretty clearly, though, is that the strongish pound has helped hold down inflation. Were the pound to fall by very much and imports were to become more expensive we would lose an important advantage. Curiously much of industry and the manufacturing unions still want a weaker pound, not realising that were that to happen there would have to be even faster rises in interest rates to choke off imported inflation.

So will the pound weaken? It may, particularly given the recent weakness of the dollar. You can see a touch of recent weakness in the middle graph. Some fall is built into the Bank of England assessments. Back in November, when the pound was just under 107 on the sterling index, the MPC assumed that the pound would decline to 104 over the next couple of years. Well it has done that already. That of itself is no cause for alarm; the pound is after all still stronger than it was a decade ago and for that matter stronger than it was at the beginning of last year. But currencies can become unfashionable, as did the euro and as the dollar may now become. Some of this dollar uncertainty may spread to the pound. While my own view is that sterling will gradually tend to strengthen over the next few years, it could be knocked back in the next few months.

The danger then would be that the Bank would have to raise rates more quickly as inflation climbed. Doubtless our exporters could live with a rise in rates provided they also had a slightly weaker currency but what would be the effect of rising rates on domestic demand?

House prices are of crucial importance. The perceived wisdom seems to be that they either have reached a plateau or will do so soon, but that they won't fall much. That may well be right but have a look at the bottom graph.

It comes from another independent consultant, GFC Economics, which points out that while overall house prices are still below their 1988 peak in real terms (top line), the London premium (bottom line) has already started to decline. This ratio between London house prices and prices in the UK as a whole also peaked ahead of the national housing market during the last cycle and so may be a lead indicator of general house price movements.

Conclusion: the fact that London house prices are already tailing off could herald a more general weakness in the next couple of years. If that were right, it would be a case for being quite careful about raising rates. We absolutely don't want to precipitate another housing bust: much better to allow a few years of stagnation as incomes rise.

All this points to caution. The whole world interest rate cycle has started its upward phase. I expect the European Central Bank to make a move ahead of the holiday period and the Bank to move in August. The Fed? Probably not until September. But while those predictions may be wrong it is virtually certain that rates everywhere will be higher a year from now. The rises will be quite slow and quite muted but there is no escape from them. People here – businesses and individuals alike – should get their finances in order so that they are ready to cope.

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