Rate peak may be near the trough

PRESENTED with the cheapest financing costs in their lifetime, a generation of consumers is making the entirely rational decision to reduce saving and increase borrowing and spending.

After all, this is exactly why the Bank of England changes interest rates in the first place: managing near-term demand in the economy to keep spending, inflation and employment as close to sustainable levels as possible.

Over the past two years, this has helped the UK economy to stay afloat at a time when the external waters have been very stormy indeed.

But the rapid build-up of household debt has left many asking if the Bank has solved one problem only to create another.

With house-price inflation no longer providing a big boost to spending power, and with real take-home pay declining, UK households are more vulnerable than ever to an increase in interest rates.

It is important to remember, though, that this has been an economic cycle far different to those experienced at any time in the modern era.

Despite the consumer's painful demise being widely prophesied, it remains more likely that the adjustment to slower rates of growth over 2004 and 2005 will be weathered relatively smoothly.

Even when interest rates do start to rise again (as some already predict), it is likely that the next peak in UK base rates will be closer to what would have been considered a trough in interest rate cycles over the past 30 years.

Indeed, there is every reason to consider the past 30 years as the exception, rather than the norm.

We have seen a huge accumulation of consumer debt so far this decade, to a record high of 90% of GDP by the first quarter of 2003 from 75% at the start of 2000.

Despite this, the fall in interest rates over the same period, from 6% to 3%, has kept the cost of servicing that debt close to record lows.

That said, UK borrowers still pay a consistently heavier charge for credit than their US and European counterparts. Since 1980, UK interest rates have, on average, been 3 percentage points higher than those in Germany and two points higher than in the US.

This is a hangover from the UK's poor inflation track record between 1970 and 1990, which contributed to a lack of credibility in monetary policy.

The interest rate gap has narrowed and credibility has improved over the past decade. Indeed, since the establishment of the Monetary Policy Committee, no one would argue that the UK's monetary regime is any less credible than those of Europe or the US.

But achieving a lower average base rate will take time, and will need to be carefully judged against the backdrop of the economic cycle.

Looking at UK interest rate and inflation data over the past 300 years, the period from the 1970s stands out as being unusual in the incidence of persistent inflation and soaring interest rates.

If we consider many of the rigidities that invited inflation pressures since the 1970s to have dissipated, then perhaps the reality going forward - for both inflation and interest rates - is going to look a bit more like the preceding three centuries.

Before 1970, the average inflation rate was just 0.7%. In the three decades since then, the average was 7%. This has been reflected in the change in base rate behaviour, which averaged 4% in the period before 1970 and 7% afterwards.

So the longer-term reduction in inflationary pressures suggests that base rates over the coming decades are more likely to fluctuate between just 2% and 5% rather than the 3% to 17% range seen over the past 30 years.

This is reassuring news for those fearing an almighty crash on the back of interest rate rises, but a sobering reminder that without wage inflation, the value of household debt will impose a longer lasting burden than its current cost would imply.

Steven Andrew is chief economist at ISIS Asset Management.