Hamish McRae: I can see the light at the end of this tunnel

Wednesday, 16 July 2008

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It is getting worse and it will get worse still before it gets better. But we are, I think, closing in on the turning point.

There is at the moment a yawning gap between what is happening on the financial markets and what is happening in the real economy. The markets are losing their nerve: it doesn't really matter whether you are looking at the US, UK or any other developed country for this is everywhere. But the real economy in almost all Western countries is still growing, albeit much slower than before.

You could understand there being some gap, for while markets are shaped by the economic outlook, they are a lead indicator. In their incoherent way they try to anticipate what will happen to interest rates, company earnings and so on. But the gap seems too wide. Sure the economic outlook has deteriorated over the past couple of months but not that much. So what is the explanation?

It is partly inflation and partly the credit crunch. We had those new inflation figures for the UK yesterday and they were dreadful. If you think the consumer price index at 3.8 per cent is bad look at the retail price index, the one still used for adjusting benefits, many pensions, the return on index linked gilts, student loans and so on. That was up 4.6 per cent, which save for a brief blip last year, was the worst since August 1991.

Worse still was the RPI excluding mortgage interest payments. That index, the one originally used by the Bank of England for monetary policy, was up 4.8 per cent, the worst since June 1992. And, as we all know, for most people the real rate of inflation is higher still because the things we have to buy, such as food and fuel, have gone up by more than the things we might like to buy, such as clothes and electrical kit.

But it is not just inflation itself; it is an awareness that there is nothing much that can be done about inflation itself or its consequences. Nothing much can be done about inflation because the sole weapon to tackle it, higher interest rates, takes a year or more to take effect. And the extent to which that weapon can be deployed is limited by the other problem the world faces, the difficulties of the world banking system, brought about by excessive lending on property in the US and elsewhere.

Inflation everywhere is high: it is higher still in the eurozone and the US and terrifyingly high in China and India. Here our concern is that the Bank of England cannot cut interest rates while the inflation rate is above target. So it cannot help the housing market (and our monthly budgets) by cutting the cost of mortgages.

But while it is economically incorrect to say so, I am not sure it would make a huge amount of difference were it to cut rates. The US has official interest rates of 2 per cent but house prices are plunging, with the knock-on effect on the entire financial system. Were it to cut rates to 1 per cent I don't think it would have a blind bit of impact on US confidence. Correction: because it would seem so desperate, that would make matters worse.

So here, even if the Bank of England's monetary committee could credibly announce a cut of, say, half a percentage point in rates (which it can't) that would hardly revive the housing market. The number of housing sales is at a 30-year low but the thing that is clobbering sales is not so much the price of money but its availability.

The banks don't have the money to lend and they cannot, as they could a year ago, bundle up their mortgages and sell them on to someone else because that market has shut down. So they have to ration their new mortgages to the most creditworthy borrowers, which intensifies the squeeze on house prices.

And this is global. In the past few days the pressure on the world banking system has intensified. When the credit markets started to unwind a year ago most of us thought that there would be several months of disruption. Those months have stretched out to nearly a year, which is long by past standards.

The usual signal for a turning point is that some large banking enterprise has to be rescued by the government concerned. Since the problem originated in the US, this was bound to be a US one. The rescue of Bear Stearns, the investment bank, was not big enough.

What is happening now to Fannie Mae and Freddie Mac, those twin government-sponsored home-lending institutions in the US, is huge. They are not banks as such and there is no formal guarantee from the federal government. Thus it is not clear in what way they will be supported. But the potential damage to the US banking system, the dollar and to financial credibility of the country is so great that this will not be allowed to get out of hand. You never know till long afterwards but this may be the turning point for the world banking system.

But of course, even if it is, confidence will not spring back quickly. It won't come back until the world banking system is recapitalised and reshaped – expect more mergers and takeovers like the Alliance and Leicester one, maybe some bank rescues on the Continent and in Asia. And the inflation numbers won't come back until this surge in energy and commodity prices has moved through the system.

But come back they will. I have been looking again at surges in the retail price index in previous cycles over the past 60 years. Back in June 1948, inflation was 9.7 per cent; in September 1951, during the Korean War commodity boom it reached 12.3 per cent; in August 1971, it was 10.3 per cent; in August 1975 after the first oil shock, it was 26.9 per cent; in May 1980, it was 21.9 per cent; and in September 1990, it was 10.9 per cent.

So even if the RPI reaches 5 per cent, which it may, what is happening now is nothing like previous inflationary surges.

So to be clear, both the surge in inflation and the disruption in the financial markets have some way to go. But we are coming to the sort of point on both where we will be able to look across the valley and see the hills beyond. I am not sure I would want to call them sunlit uplands but you know what I mean.

Still uncertain is the behaviour of the real economy. That goes for here in the UK, elsewhere in the developed world and – tremendously important – in what we still call the developing world, though that has fast become a misnomer. We know there will be a slowdown and that it has already started but we don't know how serious or how long. Nor do we know the relative performance of the various countries, though some will pull through in better nick than others.

But I take some comfort from those inflation numbers listed above. As far as inflation is concerned this is nothing like the 1970s; or the 1980s; or the 1990s. Nothing at all.

h.mcrae@independent.co.uk