Yes, Interest Rates Will Go Up - but When? Best Keep an Eye on the ECB

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Interest rates are going to go up. Few economic forecasts an be made with 100-per-cent certainty, but this is surely one. The question is when? That is harder, but let's start with "this year", for I would give that a 95-per-cent probability. And by how much this year? Ah, that is harder still.

You see the point. We all know that the present ultra-cheap money policy of the Bank of England cannot be sustained for much longer. It was an artificial emergency action that was appropriate at the time but it was a medicine that carries serious long-term side effects, some of which have already become apparent. We can see one of those in our soaring inflation figures but there are other hidden social costs, most notably the cut in the income of retirees who live off the interest on their savings.

On the other hand, people who were astute enough or lucky enough to get a tracker mortgage three years ago are doing well, with monthly repayments far below anything that seemed possible at the time. So we have a combination that tends to favour the strong and damage the weak, which is troubling. It is merely a question of time before rates revert to something more normal.

A further issue is the availability of credit rather than its cost. I am well aware of the criticism of the banks for failing to lend, and I am sure that there will be many individual instances of smaller companies being unable to get funds for investment. But that is not a cost issue. If you look at the detail of what is happening, it is hard to see how a modest rise in interest rates would make matters worse. A rise in rates might actually give a monetary boost because it would be coupled with greater availability. Loans might cost a wee bit more, but they would be easier to get.

Start with mortgages. Two things are happening at the moment.

One is that the interest rate on fixed-rate mortgages has started to nudge upwards. That is because the rate on two to five-year funds has started to climb, and if the costs of raw material that banks use to manufacture a mortgage goes up then they have to increase the price. Why are long rates starting to rise? Difficult to say, because it could be several things: rising inflation, a rising distrust of sovereign borrowers (including even the UK), or, conversely, more confidence about the long-term growth of the developed world economies and hence more demand for savings. Whatever the reason, the plain fact is that fixed-rate mortgages are going to cost more in the future.

The other thing is that the supply of mortgages has fallen a bit further. As you can see from the main graph, at the height of the boom at the end of 2006 half the number of new loans was coming from what might be called "fringe" lenders, mostly foreign banks that were not relying on a UK retail deposit base. When things started to go belly-up in the second half of 2007, they went back home. By contrast, the number of loans coming from the five largest UK lenders is still running reasonably close to its early 2007 levels. However, the very latest data coming through does suggest a further dip. (The Bank of England's Trends in Lending report, just out, has more up-to-date numbers from these big five lenders than it does from the banking system as a whole.)

So there is still something of a famine of mortgages. It is not realistic to expect the fringe lenders to come back to any significant extent so any rise in the supply will have to come from the big five, and their problem is attracting deposits. Now ask yourself this question. Are people more or less likely to deposit funds with a major bank if interest rates go up? The effect may be quite small but the answer must be, more likely. So if they can increase their share of deposits it follows that they can, if they wish, increase the number of new mortgages they issue.

What about corporate lending? …