Hamish McRae: Yes, interest rates will go up – but when? Best keep an eye on the ECB

Economic View
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Interest rates are going to go up. Few economic forecasts an be made with 100-per-cent certainty, but this is surely one.

The question is when? That is harder, but let's start with "this year", for I would give that a 95-per-cent probability. And by how much this year? Ah, that is harder still.

You see the point. We all know that the present ultra-cheap money policy of the Bank of England cannot be sustained for much longer. It was an artificial emergency action that was appropriate at the time but it was a medicine that carries serious long-term side effects, some of which have already become apparent. We can see one of those in our soaring inflation figures but there are other hidden social costs, most notably the cut in the income of retirees who live off the interest on their savings.

On the other hand, people who were astute enough or lucky enough to get a tracker mortgage three years ago are doing well, with monthly repayments far below anything that seemed possible at the time. So we have a combination that tends to favour the strong and damage the weak, which is troubling. It is merely a question of time before rates revert to something more normal.

A further issue is the availability of credit rather than its cost. I am well aware of the criticism of the banks for failing to lend, and I am sure that there will be many individual instances of smaller companies being unable to get funds for investment. But that is not a cost issue. If you look at the detail of what is happening, it is hard to see how a modest rise in interest rates would make matters worse. A rise in rates might actually give a monetary boost because it would be coupled with greater availability. Loans might cost a wee bit more, but they would be easier to get.

Start with mortgages. Two things are happening at the moment.

One is that the interest rate on fixed-rate mortgages has started to nudge upwards. That is because the rate on two to five-year funds has started to climb, and if the costs of raw material that banks use to manufacture a mortgage goes up then they have to increase the price. Why are long rates starting to rise? Difficult to say, because it could be several things: rising inflation, a rising distrust of sovereign borrowers (including even the UK), or, conversely, more confidence about the long-term growth of the developed world economies and hence more demand for savings. Whatever the reason, the plain fact is that fixed-rate mortgages are going to cost more in the future.

The other thing is that the supply of mortgages has fallen a bit further. As you can see from the main graph, at the height of the boom at the end of 2006 half the number of new loans was coming from what might be called "fringe" lenders, mostly foreign banks that were not relying on a UK retail deposit base. When things started to go belly-up in the second half of 2007, they went back home. By contrast, the number of loans coming from the five largest UK lenders is still running reasonably close to its early 2007 levels. However, the very latest data coming through does suggest a further dip. (The Bank of England's Trends in Lending report, just out, has more up-to-date numbers from these big five lenders than it does from the banking system as a whole.)

So there is still something of a famine of mortgages. It is not realistic to expect the fringe lenders to come back to any significant extent so any rise in the supply will have to come from the big five, and their problem is attracting deposits. Now ask yourself this question. Are people more or less likely to deposit funds with a major bank if interest rates go up? The effect may be quite small but the answer must be, more likely. So if they can increase their share of deposits it follows that they can, if they wish, increase the number of new mortgages they issue.

What about corporate lending? Here the range of lenders is rather larger and it seems that conditions may be improving a little. The Deloitte study of the opinions of chief financial officers reports that credit has now become more available and is no longer so costly, as you can see from the right-hand graph. Smaller companies, however, seem to be suffering. The monthly flow of credit to all businesses turned up for the first time in November, having been down all year. But the smallest ones, the businesses with an annual turnover of less than £1m, are still seeing their credit shrinking.

Now it may be that many of them don't want to borrow, or at least not from banks. It may be that banks are offering such dreadful rates on savings that family members prefer to chip in some money to the business and get some interest for themselves. Logic would suggest that if the gap widens between what a bank pays on deposits and what it charges on loans rises – as it has – people will try to bypass the banks. If the price of food went down and the price of restaurant meals went up you would eat more frequently at home. But in truth, no one quite knows the extent to which this is happening.

So no one should regard a modest rise in rates as a negative, and it might possibly be quite the reverse. If that is right, when is the first rise coming?

Difficult. My guess is that the trigger will not be anything that happens here in Britain but rather what happens abroad. Nothing is going to happen until the Budget, and that is on 23 March. After that, well, when will the European Central Bank make the first move? I would expect it to do so in the early summer, and when that happens there will be rising pressure for the UK to start moving upward too. Much depends on global commodity prices, and if they continue to climb still further then the ECB may bring forward the tightening it is already pondering.

So: expect the first increase in UK rates before the summer is out. And the base rate at the end of this year? Let's say 1.5 per cent.

The market wobbles offer us another chance to learn from the China syndrome

Something strange happened last week. At the start, shares were riding high here and in the other main bourses. But then there was a big wobble, and markets only recovered a bit on Friday. So what led to the change of mood?

Well, it seems – and it is always hard to deconstruct why markets do anything – that the major driver is that investors are fearful the Chinese economy might be overheating and that any measures it might take to cool things down would damage global growth.

Think about that. Ten years ago it would have been unthinkable that what was happening in a communist economy on the other side of the world would hit Wall Street. Five years ago, it would have been unthinkable that a centrally planned economy would come through a global recession in vastly better shape than the great United States of America.

So what conclusions should we draw? Nothing too strong. But I do think we should ponder why central planning of resources seems to have trumped market allocation of resources. That is not what we thought; it is not the lesson of the old Eastern Bloc and certainly not that of North and South Korea. And indeed the reason why China has done so well, aside from the huge bonus of catch-up – being able to apply western-developed technologies – has mostly to do with its market reforms. Put crudely, it has done brilliantly because it copied us.

But we need to think about what we should learn. One fact: Hong Kong has again been rated as the place in the world with the greatest economic freedom. True, Hong Kong runs on "one country, two systems". It is easy, too, to have reservations about Chinese macro-economic policy. But if we do not try to learn we will again be surprised next time the Chinese tail wags the developed-world dog.

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