In fact, with speculation mounting that it might push through a 50 basis point hike to “shock” the housing market into submission, financial markets actually met the Committee’s decision with a certain amount of relief. Central to the MPC’s deliberations was the belief that the risks to inflation over the medium term remained to the upside. It recognised that inflation was likely to fall back towards the 2% target during the course of this year, courtesy of lower gas and electricity prices and weaker import price inflation, but felt that this was unlikely to be sustained. In particular it is concerned that there is little or no spare capacity left within the UK economy and that as a result “there are signs that businesses are more able to push through price increases”. It is also concerned (as indeed are most members of the “shadow” MPC featured regularly in the Sunday Times) about the continued strong rates of growth in money and credit.
But with interest rates now at 5.5% - the highest since April 2001 - the obvious question is where do they go from here? The MPC’s decision was taken in the light of a revised set of growth and inflation projections from the Bank of England staff. However, it is unclear from the official statement whether yesterday’s move was enough, on the basis of these projections, to keep inflation at 2% in two years’ time. This won’t become clear until the May Bank of England Inflation Report is published next week (16th May). That said we believe there are very strong grounds for believing that interest rates are now at a cyclical peak.
First, we would challenge the view that there is no spare capacity left in the UK economy. True, the economy has grown at a slightly above trend rate in each of the last five quarters (0.7% in the last three and 0.8% in the two before that). But this followed six successive quarters of significantly beneath trend growth. Consequently, unless the UK economy’s long-run sustainable growth rate has suddenly fallen beneath the 2.5-2.75% a year that is generally accepted, or the economy was operating above its productive potential at the end of 2005, this simply cannot be the case. If anything, with both productivity and labour force growth having accelerated in recent years, it seems reasonable to suggest that trend growth in the UK is somewhat higher than this.
Second, the evidence of businesses being able to “push through price increases” looks tenuous to say the least. We recognise that core producer output prices rose substantially more than expected in both February and March (0.4% each time). However, as we have explained in previous papers, the overwhelming majority of this can be attributed to the recovered secondary raw materials sector, as a result of scrap metal prices surging around 10% in each month. But this sector accounts for less than 1% of UK manufacturing. Thus, for more than 99% of overall sector, “pricing power” remains weak. Indeed, we calculate that here core output prices increased by less than 0.1% in both February and March. Equally, we can detect few signs of retailers being able to make price increases stick. Admittedly, food retailers are currently having some success in this area, but in non-food retailing prices are currently 1.3% lower than they were a year ago, whilst in the clothing and footwear sector they are at their lowest since December 1986.
Our third reason for believing interest rates are now at their peak is that we continue to expect economic growth to undershoot the Bank of England’s forecast of more than 3% this year. Central to the Bank’s projection is that consumer demand will remain firm throughout 2007. We think this is too optimistic. For a start, amid all the hype surrounding the “ongoing resilience” of the consumer, most commentators appear not to have noticed that retail sales volumes grew by just 0.4% in the first quarter compared with 1.3% in fourth quarter of 2006. What’s more we can see little prospect of a swift rebound. Certainly economic fundamentals don’t point to sustained strength in consumer spending. We recognise that employment levels have continued to rise over the last 12 months (although not in the latest quarter), but increasingly the jobs created have been skewed away from traditional full time employee positions that historically have earned the highest rates of pay. In fact the number of such jobs has actually declined by 36,000 in the year to the end of February. Instead, there has been a substantial rise in the number of part-time employee jobs and self-employment, with a growing incidence of people working on temporary contracts. At the same time, the growth in employment has been increasingly concentrated in the older age groups. Indeed, 49% of the 147,000 new jobs created over the past year have gone to people above the state retirement age with a further 39% going to workers aged 50 plus. These factors, together with increased immigration from Eastern Europe, are exerting considerable downward pressure on wage growth. Little wonder real household disposable income in Q4 was unchanged on year ago levels. And with mortgage debt servicing costs, even before yesterday’s rate hike, having doubled since November 2003 when interest rates were at a cyclical low of 3.5%, income available for discretionary spending has actually fallen. As a result, we simply cannot see how consumer demand can remain as firm during the course of 2007 as has been assumed within the Bank of England’s central projection.
And finally we turn to the money supply. Although we have always maintained, having learnt from bitter personal experience during the mid-1980s, that trends in the broader monetary aggregates do have a bearing on developments in the real economy and inflation, the relationship, particularly since the mid-1990s, is volatile with the lags extremely long and variable. In particular, the equity bear market at the beginning of this decade appears to have permanently altered the relationship, raising the level of the money stock (M4 in this instance) associated with any given level of economic activity. This can be attributed to the resulting increased aversion to riskier assets and the public’s preference to hold a higher proportion of its wealth in the form of bank deposits. What’s more, much of the recent strong growth in the money supply has occurred amongst “other financial institutions”, reflecting the pick up in mergers and acquisition activity. As such, it is difficult to see what implications, if any, such developments have for the real economy. For these reasons, an assessment of monetary trends forms only one aspect of our approach to forecasting where the economy is heading. The other components of our “composite index of leading indicators” point unambiguously to the resumption of sub-trend economic growth during the course of 2007.
For these reasons we believe that 5.5% ought to prove the peak in interest rates for this cycle. Indeed, as inflation falls sharply over the coming few months and the evidence of previous increases in energy prices feeding through to underlying inflation via the labour market remains negligible the pressure will start to mount on the MPC to ease policy. Although this latest increase probably pushes the point at which this will occur further into the future, we are pencilling in the first quarter-point cut for November or failing that February 2008.