Update: read What will the latest rate hike mean for the UK economy? for the latest insight on UK interest rates.
We've made a number of predictions in the pages of MoneyWeek over the course of the year. How accurate were we? And what we can expect in 2006?
House prices: still falling
In May of last year, I warned that the housing bubble was coming to an end and the next step was a house-price bust. Eighteen months on and house prices have certainly stopped going up; in fact, some measures have had them falling month-on-month for more than a year now. Still, last month, Nationwide reported house prices were still up 3.2% in October over the same month last year. As a result, some commentators have already decided the correction is over. But, as the Nationwide house price growth chart below shows, only a supreme optimist would call the bottom in the market on the evidence of such a tiny blip in the data. Even if house prices really are rising at 3.2% a year (the data from mortgage lenders is a bit conflicted), they are still rising at less than the rate of wage inflation, so not exactly providing the capital growth that homeowners have come to regard as their right.
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Non-existent capital growth means that, for buy-to-let investors, at least, the mathematics of cost-of-carry start looking very nasty. The cost of carry is the term used in financial markets to cover the costs involved in taking a position. In property, these costs are the mortgage rate on the debt, fees, void periods, commissions and maintenance. Debt service costs alone exceed 5%, whereas rental yields in most cities are not much more than 4.5%. There are even some flats to let in London's Docklands advertised on gross yields as low as 3.67%. After costs, a gross yield of 4.5% will net you only a little more than 3%. With £500 going out for every £300 coming in, the smart money (if there is any left in the market) must start selling soon.
Consumption: the end of shopping
The sharp slowdown in the rate of house-price appreciation has already hit households' ability to withdraw equity from their homes. And as Mortgage Equity Withdrawal (MEW) has nose-dived, retail spending has hit its worst patch since records began. It seems amazing now to think that the Bank of England's Monetary Policy Committee (MPC) was arguing a year ago that the relationship between MEW and consumption had broken down, with the obvious implication that the sharp drop in the former should have had no measurable impact on the latter. Well, we now know that idea to be hokum: even a stabilisation of house prices has meant falling consumption.
This matters because consumption makes up about two-thirds of GDP, so anything that has such a dramatic effect on spending cannot but knock economic-growth forecasts too. Sure enough, Gordon Brown's pie-in-the-sky growth forecast of 3.5% for this year could in fact end up being undershot by as much as 2%, making his unrestrained spending plans look dangerously irresponsible. If governments spend way beyond their revenues, the shortfall has to be borrowed. Governments borrow by selling gilts, but an increase in the supply of bonds for any given demand requires a higher coupon (effectively a higher interest rate). This in turn slows the economy yet further.
Currently, the chancellor's getting a bit of a get-out-of-jail-free card from increased oil tax revenues on the back of oil prices going up, but while that may be making his debt forecasts look less stupid, it isn't doing much for his growth forecasts, particularly given how hard the rest of us are being hit by higher prices at the pump and higher fuel bills this winter.
The pound and interest rates
One immediate consequence of the slowdown in growth is the effect on the pound, which has been falling pretty steadily all year. A weak pound pushes up the cost of imported goods and so nudges up inflation (now at a nine-year high). This makes the Bank of England's job very difficult. Or at least it would do if, "as a number of people" have been saying, said Mervyn King last month, the Bank was "targeting total demand, or even more oddly, retail sales and consumer spending". Which, of course, as King confirmed, it isn't. Instead, its remit is to keep inflation as closely as possible to 2%. CPI is already running at 2.3%, which may not sound too exciting, but remember that last time inflation was at this level, base rates were around 6%. Now no one is looking for rates to move to 6%, but this does mean that the MPC can't cut rates to head off falling consumption and growth.
The result of this is that short-term interest rates are now higher than long-term gilt yields. This is called an inverted yield curve and is quite unusual (yields are supposed to get higher as the duration of the loan or bond increases because, all other things being equal, the longer you have to wait to get your money back, the riskier it is). What this means is that the bond market thinks short-term rates will have to remain sticky because of currency and inflation worries even in the face of worsening economic growth, which in turn means that later there will be a serious downturn that really will require much lower rates. According to US Federal Reserve studies in the US, an inverted yield curve is the most reliable lead indicator of recession they know of.
Inflation and oil
Given all this, shouldn't the Bank of England try and boost the economy with lower rates now? Maybe, but as King says, it's not what they've been charged with doing. The Bank targets inflation and the pound isn't the only thing pushing that up. Oil prices have been rising steadily now for years and, although a technical sell-off since the end of August has taken the black stuff off the evening news, there's every reason to expect it to start rallying again soon. Some people take comfort from the fact that oil prices have fallen as the northern hemisphere has gone into its winter when demand for heating oil picks up. Surely this means supply is again sufficient to meet demand, they say. Unfortunately, this misapprehension is due to a confusion over the two basic types of crude oil. Heating oil for winter use is called heavy, sour crude. This type of oil is not in any meaningful short supply. What we are talking about when we say "the oil price" are the light, sweet crudes, such as West Texas Intermediate (WTI), which are refined into performance fuels such as gasoline.
Light sweet crudes have a seasonal trough in demand at this time of year and the price often hits its lowest point around November, before picking up again. The peak in demand for the likes of WTI is in the early summer. Oil may be low today, but there's still nothing to suggest it won't be $70 by June.
It's much the same story with other commodities. The Commodities Research Bureau (CRB) index of all commodity prices has also gone quiet in the last couple of months, but there has been nothing yet to suggest this is anything but a brief respite before we set off again. Leading metals, such as copper and gold, have already recently made new highs, suggesting the next move for the index as a whole will also be up.
The trends aren't changing
We started the year saying house prices would come off in some style. Well, that hasn't happened yet, but only a brave man would say it won't, given the collapse in growth. However, to some extent the damage is already done as the sharp fall in MEW has hit consumption hard. In turn, Gordon Brown's economic growth forecasts are in tatters. Some commentators were hoping that by now the Bank of England would have cut rates aggressively to get demand back on track. However, as we have long argued, rate cuts are often tricky at this stage of the cycle, thanks to inflationary pressures. This time, these worries have been exacerbated by the rise in the oil price. Ahead of the October meeting of the MPC, analysts were united in expecting a rate cut at the November meeting. Since then, the consensus has moved and now 20% of analysts surveyed by Reuters said the next move in rates would be up.
I see little at the moment to change the trends we've already seen established. The economy will disappoint, inflation will remain stubborn and base rates will very possibly have to start rising again until the currency is firm enough to keep inflation at bay. But I expect sterling will weaken further and any increases in unemployment will only deepen the gloom for the stretched homeowners, whose mortgage rates may go up at the worst possible time. I'm glad I'm not Gordon Brown.
