It is a long time since a year ended in such confusion and
nervousness. The MPC completed its 2007 sessions with the first cut in interest
rates (to 5.5%) for over two years, just a couple of months after an increase to
6% or more was widely predicted. Yet the timing was a surprise – the only
previous occasion the MPC had cuts rates in December was in the very uncertain
climate of 1998. And the move was a bit of a gamble – little had changed since
the November meeting, when rates were left on hold. A major shift was in market
sentiment, the feeling that things were going to get quite a lot worse in 2008,
persuading the Bank to make a pre-emptive strike.
Yet, looking at the most recent numbers, it seems the economy is still
growing close to its long-term average rate. GDP growth in Q3 came in at 0.7%
and even if, as seems likely, Q4 eases a little to 0.6%, it will be bang on
trend and for the year as a whole, the increase will be a robust 3%.
Retail sales might have weakened a little on the month in October, but in
quarterly and annual terms, growth was still healthy. For all the woes in the
housing market, moreover, the Halifax index, after three monthly falls, is still
7% up on the year. And the fact that the deficit in trade on goods widened to a
new record of £7.75bn in September suggests that domestic demand is still
There is little in the behaviour of the labour market either to support the
pessimists. New jobs are still being created, albeit more slowly, employment in
the three months to September hit a new all-time high and the claimant count
unemployment measure fell back to 825,000, the lowest for three years. There are
no signs here that the economy is getting weaker.
In fact, rather than concerns about spending, there seems to be more of a
worry about inflation, the MPC’s principal policy priority. After jumping to
3.1% in March (which prompted the Governor’s first letter to the Chancellor),
the annual rate of CPI inflation edged down and for three months was back inside
the 2% target. Then in October, it moved back into danger territory. The
increase to 2.1% was largely accounted for by oil and food prices. Rising fuel
costs have already led to a jump in manufacturers’ input cost and output prices,
while a number of recent surveys (CIPS, CBI and SMMT) report ‘elevated’
inflationary risks. At the same time, weaker sterling will add to price
pressures by pushing up the cost of imports.
So, if demand growth is still on track and inflation is lurking below the
surface, what prompted the normally cautious MPC into easing policy, with more
cuts expected in the new year? The ‘credit crunch’ is obviously a factor.
The gap between bank rate and LIBOR (the rate at which financial institutions
lend to each other) is back above one percentage point, which has implications
for the price and the availability of credit. Data from the Bank of England show
the cost of borrowing for non-financial businesses has jumped sharply (by up to
1%), and small businesses borrowing relatively small amounts are very much in
the firing line.
And so are households, especially the 1.4 million whose current fixed-rate
mortgages expire in 2008. At current rates, new deals could mean repayments
rising by an average of £140 a month, a sizeable chunk out of disposable
incomes. If above-inflation price rises of fuel, energy and food are factored
in, as well as a steadily growing tax burden, it is apparent that the consumer
sector is going to be squeezed.
Earnings growth has been surprisingly muted given the strength of the demand
for labour (consistently less than 4%), and the hugely indebted personal sector
(a combined debt of £1.3 trillion, equivalent to 160% of annual earnings) is in
no position to use borrowing to support spending. It is not only households that
will struggle next year.
Public sector spending has made a significant contribution to growth in
recent years, largely because the government has been prepared to let borrowing
rise well above its own forecasts. But, as Alistair Darling admitted in his
comprehensive spending review statement, this is coming to end and a period of
restraint is now imminent.
So, with disposable income growth stalling, government spending held in
check, business investment disappointing and trade hampered by the strong pound,
all the components of growth are moving in the wrong direction. Assuming
inflation remains benign (and slower growth eases price pressures anyway), there
was room to cut rates. The MPC decided not to wait and more can be expected in
So rates are likely to come down a bit (5% by Q4) as growth slows a bit (1.5%
to 2.0%), while inflation hovers around the 2% target. A tougher environment
certainly, but not a recession – unless we talk ourselves into one. If people
believe there is going to be a recession and behave as though there is a
recession, there will be a recession. But the fundamentals say correction not