Hamish McRae: Strong UK growth and global pressures mean higher rates may come - and stay

It is a bit less than evens - according to most City economists - as to whether the Bank of England will increase interest rates to 5.5 per cent today. But it is very much odds-on that if the Bank does not move this month it will do so in May.

The timing of interest rate changes exerts an obvious fascination. When there is a surprise there are consequences for the markets. So unsurprisingly the personalities of the various members of the Monetary Policy Committee, as deduced from their voting record, are subject to scrutiny. There is the conventional classification into those who are hawks or doves, and less conventional one into those who respond predictably to the data as it unfolds and those whose judgements are all over the place.

If the timing is important for the markets, it is less so for the rest of us. A month or two either way for a quarter-per-cent change in rates has a minimal impact on family finances. On the other hand whether the top of this cycle is 5.5 per cent or 6 per cent and whether rates stay at their peak for a few weeks or a year does matter quite a lot. That big picture on rates will be determined by the fundamental economic realities rather than the deliberations of the committee.

My own instinct, for what it is worth, remains that the risks are on the upside: the peak may turn out to be 6 per cent and rates could stay fairly high for some time.

The reason for this is partly that the momentum in the economy shows little sign of slackening but also that global conditions support higher rates. As far as the very latest data is concerned, we had the Chartered Institute of Services report on services yesterday, which confirmed that activity was continuing at a high rate and that there was upward pressure on the prices that the industry was able to charge.

Private sector services are a huge part of the overall economy and therefore what the industry thinks gives a good early indication of growth overall. As you can see from the first graph, this suggests that growth is continuing at around 0.7 per cent a quarter, or a little under 3 per cent a year. Capital Economics, which plotted that graph, agrees that on the strength of this, another interest rate rise looks highly likely either this month or next.

This suggests that the economy would be able to stand higher rates without too much damage to growth. What about the need for such a rise?

Have a look at the next graph. It shows mortgage approvals and mortgage equity withdrawal. On Monday it was revealed that mortgage equity withdrawal reached £14.57 billion in the final three months of last year. The third-quarter figures were revised upwards too, to £12.17 billion. So between 6 and 7 per cent of households' real disposable income is coming from borrowing against their homes. The housing market continues to drive consumer spending.

But to what extent? Back in 2003, after an earlier surge in such withdrawals, the Survey of English Housing concluded the bulk of the money taken out in this way was unlikely to have inflationary implications. Quite a lot of the money taken out was by people moving into smaller homes, maybe using the balance to supplement their pensions. Other people re-mortgaged their homes but used the money not to spend but to pay down other debts.

However the fact remains that eventually the money raised will seep into consumption in one way or other. Further, mortgage approvals remain very strong and this will continue to support the housing market, which in turn will encourage a continuing high level of equity withdrawal. It is certainly an extraordinary contrast, as you can see in that graph, from the condition before 1998, when mortgage withdrawal was negative or minimal.

Some comfort can be gained from the level of lending to the household sector as a whole. Obviously insofar as people increase their mortgage to pay off other debts, the total lending to the housing sector remains the same. As you can see in the third graph overall lending has trimmed back a little, though it is still rising at about 6 per cent a year. There is quite a close relationship between this and retail sales.

Conclusion? GFC Economics, which produced these two graphs, reckons that the key is the level of mortgage approvals and notes that the January increase in rates did not lead to any fall-off in approvals in February. We don't yet have March figures and I suppose there is some case for waiting for those, but as I noted above, the big issue is not whether rates go up this month or next. It is how high and how long?

Here international factors will play some part. Eurozone rates are going to go up. There is no real doubt about that, for the European Central Bank is known to be worried about the long-term consequences of money supply, which is increasing now at more than 10 per cent a year. You don't have to believe in a mechanical relationship between money supply, growth and inflation to see that such an increase is not compatible with the ECB's ceiling of 2 per cent for inflation. A relatively strong economic recovery in the eurozone would support higher rates, whatever the French presidential candidates think about it.

In the US the picture is more cloudy. So much depends on the housing market and more directly on the weakness in the financial system as a result of poor quality control of the so-called sub-prime mortgage lending. If there is no systemic weakness in the US financial system (and I think it looks robust enough to cope with this one) then there is no need to cut interest rates. The latest US data shows a still-growing economy; the latest independent forecasts suggest growth this year of more than 2 per cent, in some cases much more. By the end of the year rates may well be on the way down but meanwhile persistent inflationary pressures will stop the Federal Reserve cutting rates soon.

This picture of decent growth in the UK and Europe and OK growth in America, is compounded by the fact that the rest of the global economy is booming. China, India, Russia, plus most of the other big emerging economies are racing ahead. Here in the UK we feel the force of that growth in the flood of foreign money coming into the country. That has inflationary implications. So quite apart from domestic considerations there are global forces that tend to push interest rates up rather than down.

Nothing heads in one direction forever. At some stage the global interest rate cycle will head down again. But I just think the safe assumption we should all make is that rates may go higher than most people currently expect and they may stay higher too. Sorry about that - but better to be aware of the danger and then be pleasantly surprised than the other way round.

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