Hamish McRae: If the US needs rates at 5.25% to check its housing market, what will it take in Britain?

People are more likely to borrow money if they think they will be paying back the loan in devalued currency

A pause or a turning point? The Federal Reserve board duly decided last night to keep US interest rates at 5.25 per cent. The interesting issue, however, is whether this level will prove the peak of this interest rate cycle or will turn out to be a pause on the way to still higher rates.

That matters of course for American borrowers and more generally for the economy, but it also matters for the rest of the world. If US rates have to go on up it will suggest that after a long period of very cheap money there has to be a corrective period of quite expensive money. If not, then the long-term costs of that period of very cheap money will not be as great as some have feared.

Viewed from a British perspective, a lot of this is about the impact of monetary policy on asset prices. We did not have as low interest rates as the US but they are half a percentage point lower now and they were low enough to trigger what has arguably been the greatest house price boom the UK has ever experienced.

The US has seen much the same, as to a greater or lesser extent have all developed countries bar Germany and Japan. The obvious question is whether this phenomenon is principally the result of long-term structural changes in housing markets, such as rising living standards, tighter planning controls etc, or whether it is the result of excessively low global interest rates.

In other words, are the central banks to blame - or I suppose for those who have made large windfall gains from property, should they take the credit? Of course this is not just to finger the Federal Reserve, for the Bank of Japan, the European Central Bank and - more modestly - the Bank of England have all pumped money into the system. True, the Bank of Japan has been unsuccessful in supporting its own asset prices but the money has flooded abroad and may well have contributed to asset prices elsewhere.

As for the ECB, while its policies have not so far created a recovery in property prices in Germany, they certainly have done so elsewhere in the eurozone, most notably in Ireland and Spain. The big point here is that global money supply has surged and global property prices have surged. Equity prices have recovered from the post-2000 meltdown; most bonds have done pretty well too.

But if this is a global phenomenon, which it is, the place where it matters most is in the US. How America responds will affect the rest of us more than anything else.

Some of the effects of cheap money, at least as far as US households are concerned, are evident in the first graph (above). There has been a huge and unprecedented surge in indebtedness. You can look at this two ways. That surge has made US households very vulnerable to higher interest rates. But it also means that higher rates have a swift impact on the economy, through their impact on property prices. So it may well be that the US does not need as high rates to curb inflationary trends as it did when debts were lower. It does look as though the present level of rates has been enough to stop US house prices and in some areas they are falling.

Not that the Fed targets house or indeed any asset prices. Nor does it have any formal statutory duty to try to hold inflation at a particular level, unlike the Bank of England and the European Central Bank. Its duty is the more general and unspecified one of maintaining financial and economic stability. So it has more freedom of action. However it must obviously have a key regard to inflation. As you can see from the second graph while the fall in energy prices has pulled inflation back to a more reasonable level, 2.1 per cent. But the trend in core inflation - all items aside from food and energy - has been squeezing upwards since the beginning of this year and is now 2.9 per cent. While the fall in energy prices has so some extent lead to lower expectations, the fact remains that people still expect high inflation, as the third graph shows. Are they being realistic when they say they expect 5 per cent inflation? Surely not. Inflationary expectations according to consumer surveys are now as high as they were in the late 1980s, when actual inflation was much higher. Chris Watling, at Longview Economics, points out that core inflation will be cut in the coming months by the fall in house prices: housing comes into the index as an imputed rent, and falling prices will cut the imputed rent.

Meanwhile high inflationary expectations are tricky to deal with because they affect behaviour. You are more likely borrow money if you think you will pay back the loan in devalued currency. There has been some evidence of US households trying to rebuild their savings but they have a long way to go to bring these back to historically normal levels. Were inflationary expectations to fall they would be further encouraged to do so but maybe they need a shock, which could come in the form of higher interest rates coupled with a sharper fall in house prices.

Now the Fed does not think in those terms, or at least it has not done since the inflationary explosion of the early 1980s. But during the winter, with rates paused at 5.25 per cent, it will be watching to see whether they have done enough. Rates are at a level where they lean against inflation, trying gently to squeeze it down, but not at a sufficiently high level as to clamp it down and thereby risk pushing the economy into recession. The experts are split but growing view seems to be that they will succeed. But for how long?

Our own perspective on this is interesting. The Bank managed to check the housing boom last year but it did not succeed in stopping it. House prices have picked up this year, as has economic growth. So the Bank will have to try again. If 5.25 per cent in the US is enough to check the housing market, will 5 per cent be enough to do so here? If not, will it be 5.25 per cent here in the spring?

No one can know the answer to this and you have to beware drawing parallels between the US and UK. The two housing markets are different because supply is much more elastic in the US and there is not the London phenomenon of large numbers of foreign cash buyers. The way mortgages are structured is different too, because fixed rates are more important there.

But there is enough of a parallel to act as a warning, not just to us but to any developed country that has seen a boom in property prices. Interest rates at 5 per cent or a bit above may stop a housing market, but may not be high enough to squeeze inflation down to acceptable levels. We should not assume that this tightening cycle is over by any means. I would not be surprised to see a 6 per cent peak in short-term rates here and in the US. It may not happen but it would be wise to be prepared.