Economics: Little surprise

Dennis Turner

There were no surprises this time. In the regular pre-MPC Reuters poll of economists, the vote was unanimous in favour of a rate rise. There was also some suggestion that the increase might be 50 basis points, on the grounds that if this was needed to dampen down inflation, better to do it in one go than in two steps. But in another poll (by Bloomberg), a clear majority of economists also thought the rise to 5.5% in May would be the last rate rise this year.

To have put up rates by half a percentage point would have broken new ground for the MPC. Since its inception, there have been four 50 basis points cuts (two in 1998, and one in each of 1999 and 2001), but never an increase of this magnitude.

Inflation is the key to what is happening to interest rates. Last year, rising oil prices pushed the CPI measure of inflation above the 2% target and the MPC responded by raising rates in August and November. The pressure seemed to ease when the Index fell back a bit in January and February, but March’s surprise jump to 3.1% (which triggered the first letter of explanation from the Governor to the Chancellor) made the increase in rates to a six-year high of 5.5% inevitable.

But what seems to be a simple story is not quite so straightforward. In the first place, inflation is not the virus it was in the 1970s and 1980s, contaminating most parts of the economy. Looking behind the 3.1% headline rate reveals that the prices of some goods are falling (clothing and footwear, communications and recreation), while others are barely rising (transport and household goods). The recent surge in inflation is largely accounted for by energy prices, electricity, gas and water, as well as oil and petrol. Now that oil prices have eased, and gas prices are coming down, the short-term inflation outlook is quite benign. In fact, the Governor of the Bank of England is predicting inflation will come back within the target in the second half of this year. In his letter to the Chancellor, he appeared quite sanguine about the inflation outlook.

Gordon Brown has, moreover, confused the inflation issue by changing the target. The original target was the old RPI but from 2004, he switched it to the harmonised European CPI. The key difference between the two is the treatment of housing, included in the RPI, but excluded from the CPI. Given the rapid increases in house prices, it is no surprise that the RPI has been rising even faster, at 4.8%. And it is this higher measure of inflation that is still used by unions as the benchmark for pay claims and by the government to index benefits.

So there is a risk of knock-on effects outside the MPC’s control. If house prices are a worry, it is illogical for the MPC to use interest rates to dampen them since they are not part of the target measure the MPC has been charged with managing. But higher house prices allow homeowners to use equity release as a means of maintaining spending even though their incomes are being squeezed. What would the MPC do if RPI inflation was rising while the CPI was falling and within target?

The timing of the rate increases raises an even more fundamental question. Such are the leads and lags in the system that it takes up to 18 months for the full impact of higher rates to kick in. Last year’s rises are only just starting to bite. Why then, if inflation is expected to slow in the second half of the year, was there such agreement that rates needed to rise now?

The answer is all about ‘inflationary expectations’. As growth appears to be robust and capacity pressures increasing, the MPC fears firms will take this opportunity to put up prices and rebuild profit margins, which have been squeezed by the doubling of oil prices since 2004, higher raw material costs and tax increases. In this way, inflation would spread and infect other parts of the economy. There seems to be some support for this view from sources such as the CBI Trends Survey, in which firms feel that an inflationary climate will allow them to get away with price increases. By raising rates now, the policymakers are sending signals that they are prepared to slow activity and squeeze price pressures.

There are, moreover, signs emerging that the squeeze is now happening. The number of mortgage approvals is down, personal insolvencies are at record levels, retail sales growth is easing, unemployment is up a bit and employment down a bit. The fact that imports fell by 9% in 12 months also suggests that demand may be cooling, but, since exports fell by even more, the rebalancing of the economy is still on hold.

Add all this up and it is hard to escape the conclusion that 5.5% should be the interest rate peak. The signs of a slowdown are evident and there is a consensus that the inflation rate should ease back down in the second half of the year. The interest rate environment will be very different in these circumstances.