Brace yourself for the six per cent solution
Allister Heath says it's becoming harder to fight inflation with interest rate rises — so we should expect more of them 1 nterest on debt grows without rain, said the old Yiddish proverb — but what it omitted to explain was that vigorous action by central banks also helps. Nobody understands this better than the newly hawkish Bank of England, which has finally started in earnest to turn the screws on borrowers as part of its latest war against inflation.
In an unusually unanimous vote, all nine members of the Bank's monetary policy committee agreed to increase rates by a quarter-point to 5.5 per cent in May. The only real debate now is how much higher the cost of borrowing needs to go. Another rise to 5.75 per cent is inevitable; the smart money is on interest rates peaking at 6 per cent by the autumn, taking them to their highest level since December 1998.
None of this will do the housing market or the credit-fuelled high street any good. After a remarkable spurt over the past year, the housing boom has finally started to abate. Prices are now stagnant or falling in two-thirds of postcodes around the country, according to the property website Hometrack, though this masks continuing rises for the best properties in London and the South East, which are powered by City bonuses and foreign money and are now largely insensitive to interest rates.
But the Bank is on a mission from which it will not allow itself to be distracted by the pleadings of estate agents, retailers or anybody else. It has been stung by its failure to keep inflation under control and by the fact that so many people now openly question its record in keeping prices down. To add insult to injury, the Governor, Mervyn King, was forced in April to write to Gordon Brown to explain why inflation measured by the Consumer Price Index — the debased European measure of inflation that Brown insists upon — had breached 3 per cent for the first time since the Bank was granted its independence in 1997.
And while the Bank won't admit so publicly, it is also worried about how far out of sync with incomes and rental yields the prices of most homes have become. A plausible estimate from Lehman Brothers, the City investment bank, is that the average house is now 15 per cent over-valued. While this figure is much lower than some had feared, it confirms that the market is fast approaching the danger zone in which there is a risk of a catastrophic crash.
From the Bank's perspective, the best outcome would be for house price increases to fall to zero — which higher interest rates will make more likely, by choking off demand for mortgages. The hope is that three years or so of stagnant prices, together with annual pay rises of 4-5 per cent, will be enough to get rid of most of the over-valuation. So far, it's all going according to plan: the number of mortgage approvals for new house purchases fell from 118,000 to 113,000 in March, compared with its peak at the end of last year of 127,000.
The resilience of the economy so far will have convinced the Bank that it can continue putting up the cost of borrowing without derailing growth. Figures published last week confirmed that the British economy is still doing well, growing by 0.7 per cent in the first quarter of the year and by 2.9 per cent year on year. There are no signs that the increased cost of borrowing over the past year has started to hit output or jobs.
Ultimately, however, the Bank's greatest problem is that inflation remains too high for comfort, despite having declined slightly over the past month. Even the Consumer Price Index, which dramatically underestimates the real extent of the problem, is still at 2.8 per cent, against a target of 2 per cent.
But the more realistic Retail Price Index is at 4.5 per cent: at that rate, prices will double by 2023, which shows just how far from price stability Britain really is under Mervyn King's supposedly watchful eye. What makes this even worse is that many people, especially those who consume a lot of expensive services and have a mortgage, are faced with much higher personal rates of inflation; my own is at around 6.6 per cent, according to the calculator thoughtfully provided on the Office for National Statistics website.
There are several reasons why inflation is so high The first is that there is far too much money sloshing around the economy. Latest data shows that the broad money supply grew by 13.3 per cent in the year to April, the highest figure since last October. For a long time the Bank dismissed the concerns of those of us who argued that too much money chasing too few goods and assets could not be a good thing for inflation; now, however, it is clearly paying far more attention.
Glob alisation is also increasingly playing havoc with British inflation. Until recently, our increased reliance on foreign goods helped make the Bank's job much easier. Between 1996 and 2004, prices of imported goods (excluding oil) fell by 20 per cent, according to Citigroup. Not only did we import more and more consumer goods from low-cost countries such as China and India, but the pound also strengthened, automatically reducing the cost of goods purchased from abroad.
Together with huge efficiency gains pushed through by retailers such as Tesco, cheap imports had a hugely positive effect on consumer price inflation, allowing the Bank of England to keep interest rates artificially low and helping to fuel the credit and house-price booms.
Over the past two or three years, however, globalisation has turned into a force for higher prices. Commodity prices have surged and many emerging economies have increased their export prices. The prices of 'core consumer goods' (a measure which excludes food, drink, tobacco and energy) fell by only 0.3 per cent year on year.
But while the forces pushing up inflation are clear enough, a subtle change in the structure of the British economy means that it is becoming harder for the Bank to control demand by hiking rates. By signing up for fixed-rate mortgages, many borrowers have temporarily shielded themselves from a higher cost of borrowing. Capital Economics calculates that almost 70 per cent of recent new mortgages have been taken out at fixed rates, with about fourfifths of these set for between two and three years. Until these mortgages reach the end of their fixed periods and revert to a basis which reflects rate changes, the Bank will struggle to have much of an effect on consumer spending. Once upon a time a halfpoint rate increase would have done the trick; now at least a full percentage-point rise will be needed to have the same impact. All of which bodes ill for anybody planning to buy a house any time soon. Six per cent interest rates, here we come.
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