Why an interest-rate hike is way overdue

On 5 March last year the Bank of England cut interest rates to just 0.5%: the lowest rate in the Bank's

315-year history. The move was part of an emergency package designed to shore up an economy teetering on the edge of an abyss.

In the last few months, however, something worrying has happened. Rates have stayed at that all-time low for 17 straight months now. And the evidence is starting to emerge that the market is beginning to be seriously distorted by money that is virtually free. If rates stay at these levels much longer, behaviour will have changed so much that the shock once markets start to get back to realistic levels again is going to be huge.

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In the three centuries that it has been in existence the Bank has never pushed rates as low as this before. As a temporary, emergency measure, it was perfectly understandable. The credit crunch had tipped the global economy into a deep recession. There was plenty of talk of the threat of deflation (even if there wasn't much actual evidence of it). Something had to be done. Pushing rates down to almost zero was about the only weapon the Bank had available. But now that low rates have been maintained for nearly a year and half, they're starting to be accepted as normal. For the first few months, people realised they were the exception. Now they just think that is what money costs.

What's more, there's little sign of rates rising soon. At the last meeting of the Monetary Policy Committee (MPC) only one member, Andrew Sentance, voted for a rate rise, and that was only by a quarter of 1%. The rest of the MPC seems happy to keep rates on hold for the foreseeable future. Yet at these levels, money isn't just cheap it is, in real terms, effectively free. Inflation remains stuck stubbornly above 3%. The real interest rate is negative and has been for more than a year now.

A basic rule of economics is that once you change the price of something, you change behaviour too. With money now virtually free, three things are happening.

First, there's a big upsurge in mergers and acquisitions (M&A). BHP Billiton's $43bn bid for Potash is only one example. This August has seen more takeover deals than any August since 1999, at the height of the dotcom boom. No doubt the autumn will be even busier. It makes sense. If a firm can borrow money at less than 1% and go out and buy a business yielding 6% or 7% a year, then it isn't very hard to make a deal stack up financially. When CEOs thought 0.5% rates were temporary, they held their fire. Now they're looking permanent, they're starting to do deals based on very cheap money.

Likewise, the housing market remains suspiciously buoyant despite the slump in the economy. Again, it is being propped up by ultra-cheap money. There aren't any mortgages available at 0.5%, but there are plenty of trackers available at less than 3%. Initially, record low rates were a windfall for homeowners. Their monthly mortgage payments came down dramatically. By now, however, we should assume that many people have bought properties on the assumption that they will be paying about 3% a year interest on their mortgage forever.

Savers, too, have started to change their behaviour. There isn't much point in putting your money into an account paying 0.25% a year or less. It's hardly worth the trouble of filling in the form. There are plenty of anecdotal reports that savers are switching to corporate bond funds, or high-yielding equities, in record numbers. It is hard to blame them. There isn't any point in collecting practically nothing on a deposit account when you could be making 5% or more elsewhere.

The trouble is, as near zero rates come to be accepted as the norm, behaviour is changing in all sorts of ways. People are starting to act as if those rates will remain indefinitely. But, of course, they won't.

The one thing you can say for certain is that if a price is at a three-century low, there is nothing normal about it. It's clearly exceptional. The think tank Policy Exchange predicted last weekend that interest rates could be back up to 8% in two years, as the impact of the huge expansion of the money supply fed through into prices. That may or may not be accurate. But one thing seems certain: a return to a more normal rate of around 5% is guaranteed at some point in the next two or three years.

When that happens, it is going to be a shock. Companies will have made huge takeover deals based on free money. People will have bought houses thinking they would only have to pay 3% on

their debts. Savers will be invested in bond funds that may well fall sharply in value once rates start to rise again. The economy will have adjusted to near zero rates and it will be extremely painful to have to start paying for borrowing again.

The Bank of England probably made the right decision in slashing rates close to zero. The economy did need rescuing. But by allowing that rate to remain in place so long, it is taking a big risk that companies and individuals get so used to free money, they won't be able to cope once rates do finally start to go up again.