We are not there yet and won't be for some months to come but it is time to start thinking about the first rise in UK interest rates. The logic is simple. Rates are artificially low, far below inflation, and this is not sustainable in the medium-term. The economy is growing at a decent pace and inflation is way above target and not showing much sign of coming back down.
Of course there is still a huge amount of leeway to make up and of course we are in the early stages of the forthcoming fiscal squeeze. It does make sense to have a reasonably expansionary monetary policy to offset the tighter fiscal policy. But there is a difference between having enough money in the system and having ultra-cheap money. If it were safe to increase rates, the Bank of England's monetary committee would be obliged to do so.
To be clear: there is not going to be a rise in rates this month, next month or indeed until the effects of the rise in VAT in January have fed through the system. The Bank's monetary committee has had only one member voting for an increase in rates (and one voting for further monetary easing) and that balance will not change fast. But two things are happening, quite aside from inflationary concerns, that increase the case for getting interest rates back to normal.
One is that it is becoming evident that these very low short-term rates may be having a perverse effect. You can see that in mortgage finance. The supply of funds is very low: mortgages may be cheap but you can't get them. Part of the reason for that is that all the foreign and fringe lenders have left the market, but part is that the mainstream banks and building societies are offering such dreadful rates to savers. If a building society could offer a better rate it would collect more deposits and make more loans.
The other is that, thanks to the credibility that the Coalition has built up, long-term rates have fallen. Rates swing around, of course, but as a rule of thumb the Coalition is borrowing at around 3 per cent, whereas its predecessor had to pay 4 per cent. That pulls down the cost of long-term finance for all borrowers. So provided long-term rates remain low, a rise in short-term ones will not do huge damage to demand.
Put these two points together and, were the Bank to put up its rates, you might actually see a healthier flow of mortgages, not the starvation rations the housing market is living on at the moment.
So when will the first rise in rates come? Research by Nomura suggests a quarter point increase in May next year, followed by a gradual climb to 2.25 per cent by the end of 2012. That projection is quite a bit faster than the view of the financial markets as a whole, but it feels to me to be about right.
In strategic terms it would be buying some credibility for the Bank, which may be needed as the European Central Bank will probably also be increasing rates next spring. And in practical terms it would not damage demand. Pulling back on quantitative easing – reversing the flood of money the Bank pumped into the markets last year – will take longer and needs to be done very gradually, given the amount of debt the Government still has to sell over the next few years.
If this line of argument is right – that gradually and progressively from next spring onwards we will see monetary policy coming back to normal – the UK will be following a quite different set of policies from the US. The Federal Reserve is expected to announce another chunk of its version of quantitative easing (dubbed QE2) this week, and there is no signal at all of any rise in rates. But the US is different from the UK – and not just because the reserve currency status of the dollar enables it to take bigger risks. Its housing market is in a worse state than ours, unemployment is higher and consumers are more fearful.
Of course, if our economy were to tank in the first part of next year, and some pause in growth does remain on the cards, then it would seem odd to be tightening monetary policy. But the world recovery does look to be broadening and deepening and abnormal monetary policies, like abnormal fiscal policies, have eventually to be reversed.
A return to civilityis good for everyone
Last Saturday I went to the mass rally on the Mall in Washington organised by the comedian Jon Stewart. It was jolly enough but pretty partisan, for there were not, to judge by the placards, many Republicans there.
But thinking about it afterwards it struck me that there is a need for civility and sanity, indeed a more bi-partisan approach, in US economics too. For the endless arguments about the fiscal boost – is it working?, should it be bigger?, should it be ended? and so on – have been destructive of economic confidence.
Today, aside from getting the results of the election, we are also due to get a statement from the Federal Reserve about its next bout of quantitative easing. It will do something, but ahead of the announcement no one seems to have a clue how big it will be. This carries the danger that there will be another row, with one or other side being disappointed: more noise, less civility.
And beyond that, there is a danger of a clash between the Fed and the new Congress, with the Fed finding its expansionist policies opposed by the sharp swing to the right. Maybe, some way down the line, the Fed could find its independence questioned on the grounds that it has exceeded its mandate.
What we do know is that politics in Washington will be gridlocked. But that, paradoxically, may force more civility. There has not been much of that with the Democrats having the presidency and both houses of Congress, so things could not be much worse. Now compromise may be forced on all.
You are not supposed to say that gridlock is good, but looking back, both the economy and financial markets have tended to do better when the President and Congress come from different parties. Fingers crossed, for this matters for the rest of us too.