Hamish McRae: A rise in taxation after the election is a certainty. Will interest rates rise too?

The theatre of the election will run a while longer, but meanwhile the real world of the economy continues. The problem is partly that the noise of the theatre tends to drown out the signals from the economy and partly that any economic story gets interpreted through the prism of the election campaign.

The theatre of the election will run a while longer, but meanwhile the real world of the economy continues. The problem is partly that the noise of the theatre tends to drown out the signals from the economy and partly that any economic story gets interpreted through the prism of the election campaign.

An obvious example has been the collapse of Rover, but even the small rise in unemployment yesterday (of which more in a moment) was seen as a sign that maybe the huge achievement of getting the number of unemployed down was a little less secure. Underlying these concerns is the fear that after the election there will further increases in interest rates as well as increases in taxation.

The latter are pretty much "in the market" as professionals would say. Not only does everyone expect tax increases, a sharp rise in the burden of taxation is projected in the Treasury's own figures, as revealed at the time of the Budget.

The International Monetary Fund confirmed this widespread view yesterday. But the direction of interest rates is really much harder to predict. Nothing is going to happen in the middle of the election campaign itself, for there is an unwritten convention that predates the setting of the Bank of England's Monetary Policy Committee, that rates are held steady through the election period. But afterwards the City seems pretty evenly split as to whether rates will go up one more click in June or whether this is the top.

The background to all this is a slowing world economy, beset by high commodity and energy prices and the huge imbalances between the US on the one hand and Japan and China on the other. This slowdown will shape our own economy through the autumn and beyond.

How serious? Who can say? Just yesterday the US came up with some soft consumer spending figures, suggesting that higher gasoline prices were biting into family budgets. But there was also a report from the International Energy Agency in Paris suggesting that there would be a "correction" in the oil price - a lovely expression, suggesting as it were that the recent surge in the price was a bit of a mistake.

Maybe the easing of US consumer demand is a bit of correction too. We shall see. What is beyond dispute is that the main forecasters are trimming their growth estimates for this year and that there has been a turndown in the Organisation for Economic Co-operation and Development's leading indicator, that signals turning points for the main developed economies. The lead indicator is not yet suggesting there is an imminent recession as it did in the early 1990s and around the millennium. But it does signal some sort of dip.

Return to Britain and you can see a similar dip signalled for house prices. This is one of those issues where there is too much information of a not terribly helpful nature. The tiny variations between the monthly tracking by Nationwide and Halifax are really neither here nor there - at the moment prices are flat and have been for some months. In any case, what is happening to prices is a backward-looking indicator of the state of the market.

There is no leading indicator of house prices but the nearest equivalent shows whether people looking for homes think prices will rise or fall in the coming 12 months. Confidence is higher than it was in November and December, when most people expected a fall, and is now pretty evenly balanced. But it is a long way from the heady days of spring a year ago, when just about everyone expected prices to rise over the next year - correctly as it turned out.

HOUSE PRICES

The trend of house prices is one very important force for determining the Bank's policy on rates because prices encourage people to borrow against their asset, and these borrowings feed through into consumer demand.

Another key indicator is the trend of earnings. Alongside the small increase in unemployment revealed yesterday were some strong earnings numbers. Headline earnings shot up to 4.7 per cent year on year, but if you strip out City bonuses and allow for other seasonal factors it seems the underlying growth in earnings remains at 4.3 per cent, which apparently is deemed not to be a concern.

Earnings growth is higher than it was a couple of years ago, but it does not now seem to be on an upward trend, if anything the reverse.

So what is going to happen? I don't think it matters terribly whether the peak in interest rates this cycle is 4.75 per cent or 5 per cent. In psychological terms it may have some effect, though that could even be perverse. People might greet a rise in rates to 5 per cent with a "phew, now that is over and rates will soon come down" attitude. What does matter is the speed at which rates might fall and that will depend on global as well as domestic factors.

The global factors include, of course, energy prices and the trend of inflation elsewhere. There is a lot of concern that inflation will become more of the worry in the United States. There is talk, I think rather absurd talk, that the European Central Bank would like to increase rates this summer. I say absurd because the danger for the eurozone is not inflation. It is a flop in the second half of the year, with growth falling below its present crawl to something near a standstill. The ECB has been consistently over-optimistic in its growth forecasts for the past four years - it is quite embarrassing how bad it has been.

Here, though, the official forecasts have been pretty accurate and suggest only a slight slowing of growth. However, both the IMF and the private sector forecasters think growth will slow considerably. The market believes that as a result rates will need to be pretty flat for a while: no need for much of a rise, but also not much prospect of a significant fall.

CHEAPER MONEY

Taking the three-month money-market rate, which is somewhat more representative of the real cost of money than the Bank's base rate. Lehman Brothers think that while there is a 40 per cent chance of that last quarter percentage point going on base rates, the two-year outlook is for money to come much cheaper.

Indeed, it thinks that the Bank will push rates down by 1.25 per cent over the next two years: so base rates would be perhaps 3.5 per cent by 2007. So another leg of the house price boom? Well, not necessarily because the fall in rates would be in response to a weaker economy.

If taxes really do go up by the amount predicted in the Budget, this would take a lot of consumer demand out of the economy, so the country might not need a tight monetary policy to hold down inflation. A tighter fiscal policy would do the job instead.

Bottom line? We really are close to the top of this interest rate cycle. Rates may not be down in two years by as much as Lehman expects, but they will be lower than today. But since taxes will be higher we will not feel that much richer overall.

A world of slower global growth inevitably also means a world of slower increases in living standards for UK consumers - and voters.