The surprise is anyone is surprised. The writing was on the wall for all to read three years ago. But moving forward, we wonder if a new writing is appearing. Be careful, here, Bank of England, don’t forget we are dealing with long term forces. What you do now may not have its full impact for 18 months, perhaps even, a lot longer.
Three years ago we regularly scratched our head. We used to say that if inflation is not the eventual result of all the excess government and consumer borrowing, then just about every macro economic text book ever written will have to be thrown away.
But, it appears many, and the Bank of England is very much included in this list, buried their head in the sand.
The high level of consumer borrowing, the Bank used to say, was affordable because asset prices were going up. In short, our borrowing was matched by higher house prices, therefore it was affordable. Can you spot the flaw in that argument?
In fairness to the Bank, it was in a tight spot. After 11 September 2001, central banks made a concerted effort to keep the global economy from crashing. Rates were dropped, perhaps too far. Earlier this year, the Bank of England’s former governor Eddie George told a Treasury Select Committee, “We knew that we were having to stimulate consumer spending. We knew we had pushed it up to levels which couldn’t possibly be sustained into the medium and long term. But for the time being, if we had not done that, the UK economy would have gone into recession just as the United States did.”
Lord George added “My legacy to the MPC, if you like, has been ’sort that out’.
So, maybe you can forgive initial enthusiasm to lower rates. But when the UK economy stayed well away from recession territory, and it was clear the uninterrupted run of economic growth was continuing, why were interest rates so low?
Why was it, for example, that in August 2005 the rate of interest was lowered from 4.75 to 4.5 per cent?
We were in good company. The Economist magazine also used to warn that inflation was slowly gathering momentum.
Of course, two things made the difference. The Internet helped encourage unprecedented price competition, and there was China. So, instead of inflation occurring on the high street, it occurred in the backstreets away from the shopping roads. In appeared in housing estates, in residential areas: inflation occurred in the form of higher house prices. It seemed inevitable that sooner or later this house price inflation would be transferred to the high street.
Today, maybe the Internet effect has worked through the system, or, to put it another way, some prices fell thanks to price competition, but they aren’t going to fall much further.
As for China, it appears that the gradual rise in its consumer society behind the Great Wall means that global demand is rising. Combine this with the use of food crops as biofuel, and you see why the cost of food is increasing.
As for consumer spending, this has been encouraged by higher house prices, creating a false view of how much we could afford to spend.
This is why inflation is higher today, this is why the rate of interest keeps going up. It’s down to what happened some time ago.
But, equally, it appears there are dangers. And just as the Bank of England was far, far, too slow to spot the dangers of inflation, maybe there is a risk it is now being equally slow to spot the opposite danger.
Recently, the FT warned that interest rates could hit 6.25 per cent. The Bank of England has assumed rates wil hit 6 per cent, in its latest inflation report.
And yet there are plenty of reasons to think that actually the economy is going to slow anyway.
For one thing, there are a million people on fixed mortgages who will be seeing an end to the fixed term later this year. Or so says the Council of Mortgage Lenders. When they took out their fixed mortgage, interest rates were probably 4.5 per cent; when the term comes to an end rates will be 5.75 per cent - that’s a big hike.
In any case, remember that report we published last month from Ernst and Young. It said that after tax contributions, mortgage payments and monthly household bills, the average family now has just over 22 per cent of its gross income left over, as opposed to over 28 per cent in 2003. Ernst and Young says that the average household now has £837.53 to spend each month after total fixed monthly outgoings, compared with £898.54 in 2003/04.
According to the Woolwich the average amount of income spent on mortgages by people in their 20s, is 32.4 per cent, the highest level since records began in 2002.
If rates stay at this level, the consumer will feel the pinch, the economy will slow, it will just take time. It takes time for excess borrowing caused by rates that are too low to create inflation, it takes time for hard up consumers reining back on their spending, to ease inflation
If you are driving a heavy car, and you press the accelerator, you know the vehicle won’t respond straight away. But if you keep the pedal down, then all of a sudden the acceleration can be too much. These are the problems a learner driver must face. This is what has happened to the UK economy. But the learner driver can also slam the brakes too hard, in panic, because the vehicle does not react instantly. This has become a danger for the UK.
There is a danger, that just as the Bank of England kept pushing its foot on the gas, even before it had given the economy time to react to the initial push on the accelerator, now there is a danger it is going to keep pressing the brakes, even though the economy has only just reacted to the initial depression on the brake pedal.
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