Just as the UK market was looking towards the US for more unpalatable economic surprises, one emerged right in our own back yard with the news that inflation is currently running above 3%.
Anything over 1% away from the Government’s 2% target requires a letter from the Bank of England to the Government explaining what has happened. So the Governor of the Bank of England, Mervyn King, sent such a letter to the Chancellor Gordon Brown with his views on this worrying inflationary figure – the first time in ten years that the letter has been required.
The news certainly shocked the market, which took the rest of the day off and was still feeling the hangover during the following day or two.
One impact of this news is that if City economists had the slightest doubt around another rate hike in May to 5.5%, this was swiftly removed. Indeed, the current bone of contention is that there may even be a further rise later in the year to 5.75%, with the real pessimists even suggesting the possibility of 6%.
Set against some concerns about the UK borrower, not to mention the fallout from the US sub-prime market fiasco, this will do little to soothe the nerves of investors who were just coming to terms with the February/March jitters, returning as they were to their appetite for risk.
The UK economy has, for some time, been on something of a knife edge and the general perception to date has been that the Monetary Policy Committee has played its hand fairly well.
In addition, it does appear as though inflationary pressures may ease later this year, as the substantial increases in electricity and gas prices which happened last year begin to drop off. There are also, of course, the effects of previous interest rate rises washing through to the economy, all of which could point to an inflation figure rather nearer the Government’s target and therefore reduce the threat of rising interest rates.
With hindsight, some have suggested that the last interest rate decrease – in September 2005 – was perhaps a little previous and that without such a drop this week’s numbers would have had less of an impact. The MPC would certainly contest that based on the figures available to them at the time, the move was justified.
The other major factor in this debate is the current strength of sterling. The headline writers have readily welcomed the $2 pound, but the increase to this (psychologically important) level has been gradual and has not happened overnight. Of course, many leading UK companies do much of their business in the States – Wolseley, Pearson,
GlaxoSmithKline, Smiths Industries and Carnival Corporation, to name but a few – and continued sterling strength would act as a drag on growth, particularly for exporters where the US consumer would begin buying locally manufactured products and services rather than expensive imports.
In all, these are testing times for the Bank of England. The UK consumer has point blank refused to stay away from the high street as so many had predicted and, as discussed above, inflationary pressures are building, at least for the moment.
It is of course possible that the Chancellor is more concerned about the political fallout from such an announcement, as opposed to the underlying themes which are emerging.
Whatever the outcome from this week’s events, the MPC is now facing a few months in which it needs to restate its case for the market’s previous perception that it is on top of its game.
If you’d like to read more free research, comment and analysis from me and the rest of my colleagues at Hargreaves Lansdown please visit our website at www.H-L.co.uk
Richard J Hunter
Head of UK Equities
Hargreaves Lansdown
www.hargreaveslansdown.co.uk