Central to the MPC’s decision appears to have been the fact that consumer spending had recovered from its “post-Christmas dip”, which together with firmness in investment spending and business surveys suggested that growth would remain close to, or a little above, its long run average over the coming few quarters. At the same time, inflation as measured by the annual rate of change in consumer prices had risen to 2.5% in June, and was expected to remain above the 2% target for some while. Although the MPC accepted that pay growth was muted and that profit margins had been squeezed, it still believed that higher energy prices had led to greater inflationary pressures. Consequently, as profit margins and earnings growth recover, the MPC argued that “consumer price inflation will move only gradually back to the target”. Reflecting this, the MPC judged that an increase of 0.25 percentage points in the official Bank rate was necessary to bring CPI inflation back to the target in the medium term.
We believe the MPC has made a mistake. Not only, as the Committee itself recognises, is “the path of energy prices…extremely uncertain”, there is still absolutely no evidence that the admittedly high level of energy prices has started to feed through to underlying inflation. Thus, whilst headline inflation is significantly above target, the core rate as measured by the annual rate of change in consumer prices excluding energy, alcohol, tobacco and petroleum remains way below it at just 1.2% in June. True, it could rise from here, but with the economy still operating beneath its productive potential on most economists’ estimates this seems unlikely. The only way in which this wouldn’t be the case would be if the pace of economic growth through the second half of the year were to accelerate. This is clearly what the majority of MPC members are expecting, but we remain to be convinced.
First, it is far from clear that the rebound in consumer spending in Q2 is anything other than a blip related to the World Cup – retail sales were boosted by strong sales of TV’s and replica football strips in April and May and by food (and beer) sales in June. Second, and more importantly, economic fundamentals don’t seem to be compatible with sustained strong rates of growth in household spending. Earnings growth is weak and moderating following the bonus-related spike at the start of the year, whilst trends in the labour market – unemployment is rising, and the ongoing growth in employment is increasingly concentrated in the temporary sector – are deteriorating. At the same time, the sharp rise in personal sector indebtedness over the last few years means that even with interest rates at a comparatively low level, debt servicing costs have risen dramatically. And with the rise in energy prices (gas and electricity as well as petrol) also reducing discretionary purchasing power, non-energy related personal expenditure is likely to come under increasing downward pressure as we proceed through the remainder of 2006 and into 2007. It almost certainly won’t be strong enough to enable retailers to push through price increases and make them stick.
As a result, with the upside risks to inflation overstated in our view, it is unlikely that today’s hike represents the beginning of a new phase of monetary tightening in the UK. Indeed, if economic conditions pan out as we expect, interest rates are likely to be heading lower again in 2007.
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