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.