This is a significantly higher profile than the Bank predicted in February, reflecting the effects of what it described as “the (recent) unexpected increases in food and energy prices” and the expectation that gas and electricity prices are set to rise by a further 15%. It also means that Governor Mervyn King fully expects to have to write “several” open letters of explanation to the Chancellor in the year ahead. Given that the Monetary Policy Committee’s remit is to deliver target inflation over a two year time horizon, does this mean that interest rates are now at best on hold? Clearly many now seem to think so, with the Financial Times this morning running the bold headline “No rate cuts before 2010” whilst short sterling futures suggest rates will actually be slightly higher in two years’ time.
Is such gloom justified? It all depends on one’s perception of the main impact of the higher than previously expected food and energy prices. A key concern of the hawks on the MPC is that if it persists for long enough, above-target inflation will drive up expectations of where inflation will be over the medium term, thereby inducing a change in wage and price setting behaviour.
However, what are the chances of workers being able to secure inflation-busting pay increases in an environment of sharply slowing or even stagnant economic growth and rising unemployment? Pretty slim we would venture. But even if they could, is it conceivable that producers and retailers would be able to pass their increased costs onto consumers? The Inflation Report suggests there is some evidence of this in recent producer prices data, but if we delve a little deeper into the figures the only area where producers have any pricing power is recovered secondary raw materials, which accounts for less than 1% of manufacturing and is uniquely benefiting from the ongoing construction boom in China. With real household disposable incomes severely constrained by unavoidable increases in food and energy prices and now a softening labour market, and with discretionary purchasing power further eroded by rising mortgage debt servicing costs, we think it is extremely unlikely that cost-recouping price increases can be made to stick. As consumer demand grinds almost to a halt over the coming couple of quarters, producers and retailers will have little choice other than to absorb such costs in their margins. If they don’t, they will lose market share as consumers go elsewhere.
It is therefore our view that the recent rise in food and energy prices will prove to be deflationary rather than inflationary. True, the headline rate of inflation looks like staying higher for longer than previously anticipated, but if our analysis above is correct there will be no feed through into inflation more generally. There certainly hasn’t been any sign of this to-date, with the underlying rate (which excludes energy, food, alcohol and tobacco) currently running at less than half the annual rate in April at 1.4%. If we are right, unless food and energy (and utilities) prices continue to rise by at least the same amount over the next 12 months as they have over the last, they will start to drop out of the annual comparison, thereby sending the headline annual rate down towards the underlying rate.
Providing the underlying rate remains beneath 2.0% the MPC should have no hesitation in easing monetary policy quarter-point by quarter-point in the year ahead. Should it fail to do so, the downside risks to the economy, which are already considerable with GDP in any case expected to be pretty much flat in the next couple of quarters, can only increase. Interest rates may not fall as low as 4.25% by the end of 2008 as we were anticipating, but with growth now likely to be less than our forecast of 1.6% for both this year and next, they will be down to 4.00% or even lower in 2009.