Hamish McRae: Why we may soon be wondering when interest rates will start to fall

OK, interest rates will go up today and the only point at issue is by how much. But how soon will they come back down? That is surely the most interesting question now. We can see the pattern of the upward swing of the interest rate cycle reasonably clearly. We won't get the detail right but can say with reasonable confidence that rates will climb through the rest of this year and that the peak will probably be 5.5 per cent, give or take 0.25 per cent either side. In other words it would be odd if rates did not climb above 5 per cent but it would be equally odd if the peak had a six as the big number. Of course you should not rule out anything but let's say that there is an 80 per cent probability that rates will peak in that range. For what it is worth, a peak of 5.5 per cent would be consistent with the market forward interest rates.

OK, interest rates will go up today and the only point at issue is by how much. But how soon will they come back down? That is surely the most interesting question now. We can see the pattern of the upward swing of the interest rate cycle reasonably clearly. We won't get the detail right but can say with reasonable confidence that rates will climb through the rest of this year and that the peak will probably be 5.5 per cent, give or take 0.25 per cent either side. In other words it would be odd if rates did not climb above 5 per cent but it would be equally odd if the peak had a six as the big number. Of course you should not rule out anything but let's say that there is an 80 per cent probability that rates will peak in that range. For what it is worth, a peak of 5.5 per cent would be consistent with the market forward interest rates.

But there is a big difference between rates hitting their peak this autumn and then starting to come down next spring and rates sticking at their peak level right through next year. In the first instance the early decline would be associated with weak house prices, continued low inflation, a fall-off in consumption and much slower growth next year than this one. In the second case the high plateau would be associated with some inflation, no significant fall in house prices, and another year of strong growth.

The majority view is probably the latter. The market rates are consistent with a peak in the middle of next year and no swift fall-off afterwards. But I don't think we should dismiss the former one, the one that sees rates starting to come back down in the first part of next year.

The case for the long plateau first. The argument is essentially that the UK will need fairly high rates through next year to contain the growth pressures that have been building up. This view is shown in the first two graphs, which come from work by Goldman Sachs. The first one seeks to measure the amount of slack in the economy, using two different methods of calculation.

The level of spare capacity is interesting for two reasons. One is the obvious one that once you run out of spare capacity in an economy, additional demand results either in higher prices or more imports or both. The other is that the Government's fiscal sums are based on the notion that there is quite a bit of spare capacity at the moment. It is running a deficit of more than 3 per cent of GDP, yet promises to have a broadly balanced budget over the full economic cycle. True, there are some bits of investment in the conventional calculation of deficits but if we are really at full capacity, as the Goldman team suggests, then we ought not to have as big a deficit as we do now.

So is the British economy already at full capacity? The Bank of England thinks it is pretty close and has said so; the Treasury evidently disagrees.

The second graph focuses on another question: given what is happening to the economy, are interest rates too low? Take real rates (i.e. adjusted for inflation) and the answer seems to be yes - or rather, even if they are not too low, they certainly are unusually low by comparison with previous experience over the past decade. So, other things being equal, you might expect rates not only to go up but stay up for a while.

There, I think, is the nub of the debate. If this economic cycle is, broadly-speaking, like other recent ones, you would expect rates to stay up for quite a while. Past experience is that it takes quite a lot to check the British economy once it is in a growth phase. Fiscal policy will be expansionary until the next election and for some months after that. So monetary policy will have to hold things back until, perhaps, the restrictive budget in 2006.

But maybe things are different. There are several reasons why this might be so. For a start, global inflation at a finished goods level is held down by the growing importance of China in the world economy, while India is increasingly pushing down the costs of some services. Previous cycles did not have such large downward pressure, for Chinese exports were much smaller and India had hardly begun to develop its service exports. At the margin, too, the expansion of the EU to the east is putting pressure on Western European costs.

The point about this is that the indirect impact of cheaper imports is often larger than the direct effect. The imports may be quite small as a percentage of GDP but the need to compete with them forces more efficiency on domestic manufacturers and service providers.

Next, here in the UK we have already had a string of interest rate increases and there is some evidence that they might be starting to take effect. GFC Economics notes that there is a danger of monetary overkill. While the value of new mortgages has remained high, the number of mortgage approvals has fallen back this year (see third graph). So, yes, house prices still seem to be rising but they may be a lagging indicator. GFC Economics thinks that the forward indicators do suggest that the slowdown is under way. House prices may not taper off for several months and given the lags, consumption may continue to rise strongly until next year. But the corner may have been turned. Prices in London and the South-east, traditionally a lead indicator for the rest of the country, are flat.

Further to this, the fact that mortgage borrowing is so vast may make the economy more sensitive (or vulnerable) to the rises in rates that have come through. So the rise in rates would not need to be as large as it would were people carrying less debt. It may not look like it from the present data but remember the lags: it is quite possible that consumption growth will now tail off and there is always a danger when that happens demand falls away more quickly than the business community expects.

So you could argue that we are already close to some sort of tipping point; that demand will fall off quite swiftly next year; and that therefore interest rates will be able to start coming down by the summer.

Of course no one can know. There are external forces that could change everything, with the oil price the most obvious candidate there. Were the oil price to go much higher and stay there, that would take a vast amount of demand out of the world economy. Three of the past four global recessions have been triggered by a surge in the oil price. In the first instance it would push up inflation, but the central banks' response to the threat of global recession would be to cut rates. Here in the UK the Bank of England does at least have the scope to do so: elsewhere that is more limited.

But if we cannot know, we can at least look for the signals. My best suggestion for anyone wanting to know when the next fall in rates will come would be to look at the Rics' figures for house prices in the South-east. There have been some small falls in the past month. If they are still falling in the autumn, expect the first interest rate cut in the spring.