And with these, so too have market interest rate expectations. But even by the standards of 2007, what we have seen this week has been remarkable. On Monday, a Reuters poll reported that an overwhelming majority of economic commentators thought that interest rates would again be left on hold at 5.75%, which is where they have been since the quarter-point hike in July. However, by noon yesterday when the MPC announced its decision, financial markets had already fully discounted a quarter-point easing. Indeed, within minutes of the announcement the FTSE 100 had given up a 50-point gain and was sitting on a 15-point loss.
So what has happened to cause investors to alter their appraisal of interest rate prospects so dramatically? Arguably the final straw was the news on Wednesday of a third successive fall in the Halifax measure of house prices, which appeared to suggest that the long-anticipated slowdown in the housing market might be more abrupt than hitherto expected. But equally important was the weaker than expected November purchasing managers survey of the services sector, which has been the main engine of growth throughout the UK economy’s extended period of continuous economic expansion. In truth, the seeds for the reduction were probably sown last week when the Bank of England reported a 31% year-on-year fall in mortgage approvals (although they remain at a comparatively high level in absolute terms). This is what lay behind the MPC’s statement yesterday in which it said “conditions in financial markets have deteriorated and a tightening in the supply of credit to households and businesses is in train, posing downside risks to the outlook for both output and inflation further ahead.” All of a sudden, the real economy and not inflation is the MPC’s main concern.
Nevertheless, some commentators have expressed surprise that the MPC should have decided to cut rates at a time when the near-term outlook for inflation has deteriorated as a result of the latest spike up in oil and petrol prices. But such fears
merely highlight a failure to understand how the inflation process works and how it is related to the real economy.
Inflation is a lagging indicator; it is determined by demand and supply imbalances 12-24 months ago. Consequently, basing monetary policy decisions on current inflation rates would be a major error. Instead, interest rates ought to be set with a view to where inflation is likely to go over the medium term. Monetary policy should only respond to external shocks like higher energy prices if there is a danger of them feeding through into more generalised inflation. But this simply hasn’t been the case either during the surge in energy prices in the summer of 2006 or now. Indeed, underlying inflation in October was just 1.5%. The reason for this is that contrary to the fears of the MPC the UK economy continues to operate beneath its productive potential. In other words, the MPC’s long held view that “the amount of spare capacity appears limited” has been wrong.
This is also why we argued the rate hike in July was unjustified. We recognise that economic growth has been above trend in each of the last seven quarters, but this followed an uninterrupted run of six quarters of significantly beneath trend growth. Consequently, only if the economy was operating above potential at the beginning of 2004 or the UK’s long run sustainable rate of growth has suddenly collapsed could there possibly be no spare capacity left. In such an environment and because they are unavoidable, higher energy prices are in fact more likely to be deflationary as they reduce the amount of discretionary incomes consumers and businesses have to spend on non-oil goods and services.
We therefore believe firmly that the MPC is not taking any risks with inflation by lowering interest rates now. True, if the oil price remains around current levels, headline inflation is likely to remain above target until September next year, but after that it will plummet as the surge in energy prices drops out of the annual comparison. But if the global economy slows as much as financial markets currently fear in the year ahead, we are more likely to see the oil price falling back again, which will increase the chances of a significant undershoot of the inflation target in two years’ time. Although, as the chart at the top of the page shows, market expectations about interest rates have changed enormously in less than six months, the risk is that the current view of 5% by the end of next year will turn out to be too high.