Hamish McRae: Why we may be moving into a period of higher interest rates

Things have speeded up. They have speeded up despite somewhat higher interest rates and much higher oil prices. So does that suggest both interest rates and oil prices will have to go higher before the cycle comes to an end? Answers on a postcard please.

You see the point. Until a few months ago we were all worried that growth of the world economy would be choked off by higher rates and higher energy prices. It seemed reasonable. Here in the UK the rise in house prices was brought to a halt last summer and retailers had a poor autumn as people started to trim their spending. The Bank of England cut interest rates by 0.25 per cent in response to this and most of us thought that the next move would be to cut them further.

Coupled with the consumer weakness last autumn was the rising price of goods and services that people had to buy - such as fuel bills, mortgages and local government services - as opposed to the price of things that people chose to buy - such as clothes and holidays. A further twist was given by the Bank, which warned that higher taxes were also curbing personal spending.

Meanwhile the US economy, while still enjoying very fast growth, also seemed about to hit the same barriers: the housing market was starting to weaken and energy prices were biting into consumer incomes. In Europe there was little evidence of consumers spending more - in Germany they were spending less - there was very little growth in Germany and none in Italy and the mood of business was dire.

Now that has all changed. Things have picked up a bit of speed here, though growth is still unbalanced. They have carried on in the US (latest figures show 4.8 per cent annual growth in the first quarter) and at last something seems to be happening in Europe. This has been reflected in company profits throughout the developed world and subsequently by share markets. All these downward pressures have been shrugged off.

This tells us something about both energy prices and interest rates. Both are ultimately set by markets. True, short-term interest rates are set by central banks but they do it in response to market needs and have little control over long-term interest rates. They also control the supply of liquidity: they affect supply and demand for cash by feeding money into the system. So I suppose you could say that money is a somewhat rigged market. But then energy has been rigged in the past as well, as a history of the production restrictions of Opec shows.

Now there is huge demand for oil but also of other raw materials. The first graph shows what has been happening to the price of copper and zinc, both of which are more remarkable even than oil. (Henderson, which drew attention to this in a recent investor note, ponders whether there is a commodity bubble.) But this rise is not being driven by Europe or America. It is being driven by Asia, mostly China.

That leads to a central truth. This surge in energy and commodity prices is different. We in Europe have to cope with it but we do not, in the main, cause it. Anyone wanting to chart a ceiling for the oil price, or for that matter the copper price, has to ask: what price would check Chinese demand? The answer in the case of oil at least is probably higher than it is now. Global economic growth is driving the growth of the developed world, directly in the case of Germany, the world's biggest exporter, and indirectly in the case of the US because booming Asia is lending the US the money to keep growing.

That leads to the next question: what about the supply/demand balance in money? We are living with an overhang of supply, for following the 2001 US recession, the Fed pumped money into the system. Interest rates in real terms are still very low, which was reflected in the surge in asset prices, particularly house prices, in many markets. Now the supply is being checked but demand is still strong. There is a lot of cash swishing around the world hunting for somewhere that brings a decent return. There are some signs that higher interest rates in the US are taking the momentum out of the housing market (see second graph) but as yet these are still quite muted. But outside the US, particularly in Asia, there is no huge intention to borrow. Asia saves even at these low interest rates.

So in the global money market there is lots of supply and unbalanced demand. The question seems to me to be at what stage rising global confidence will suck up the liquidity that has been created, and force interest rates up further.

Within the developed world there is a rising appetite among businesses to invest more. Business confidence in the main European economies has risen very strongly (next graph). It is also strong in the UK, a relationship which Credit Suisse has spotted and which would seem to suggest that the next movement in UK interest rates will be up, not down (final graph).

Intuitively this makes sense. The central banks create a huge amount of cash and Asia saves like mad. But gradually both the cash and the savings are absorbed by rising asset prices and rising economic activity. Just as the world economy copes for a while with more expensive oil and raw materials, so too it copes for a while with more expensive money. But gradually inflationary pressures mount and the price of money is forced up. So the world gets higher interest rates. If central banks try to resist that trend, they find their currency depreciates, they impose more inflation on their people and that inflation mops up the cash.

In the case of oil, if $75 a barrel does not correct the imbalance in the supply/demand of the stuff, then the price has to go to $100 a barrel. In the case of money, if 5 per cent interest rates do not bring supply/ demand into balance then rates have to go to 6 per cent.

The easiest way to see this is to look at the UK. We have discovered that mortgage rates of 4.5 to 5.5 per cent do not seem to have checked the rise in house prices, even though prices are within a whisker of an all-time high in relation to earnings. So maybe mortgages will have to be 5.5 to 6.5 per cent.

US rates are, of course, much more important to the world economy than UK ones. At the moment there is a tug-of-war between the optimists and the pessimists. The former believe that US rates are high enough to bring about a gradual adjustment: savings will come up, the current account deficit will narrow, the dollar will fall a bit but won't have to fall very much. A new recruit to those ranks is Stephen Roach at Morgan Stanley, who has up to now been very concerned - see opposite. The pessimists believe that the recent pick-up in the pace of the world economy is a signal that neither the rise in energy prices, nor the rise in interest rates, will prove sufficient.

We will see - but I for one find that graph on UK rates an intriguing indicator of what might be in store.