Tuesday, November 11, 2003
How high is the next peak in base rates?
Posted by David Smith at 08:25 PM
Category: David Smith's other articles

IN the end the Bank had no option. Having given the clearest signal in its six years of independence that rates were going to rise, the monetary policy committee (MPC) was pretty much locked into it. To do nothing would have cost it credibility.
That may sound odd to anybody in manufacturing, where official figures show output marginally down on a year ago. The rate rise also seems to sit uneasily alongside inflation, which is 1.4% on the harmonised measure the Bank will shortly have to work with — below the likely target of 2%.

So why the rise in rates? Mervyn King, the governor, will provide a full explanation this week when he presents the Bank’s quarterly inflation report. The broad outlines are clear, however.

July’s cut in rates from 3.75% to 3.5% was presented as “precautionary”, because of fears of renewed weakness in the global economy. Since then, while it hasn’t all been plain sailing, stock markets have recovered and the American economy has turned on the afterburners, with remarkable annualised third-quarter growth of 7.2%. The global recovery, in the Bank’s words, is “gathering momentum”, while “neither household spending nor the housing market have slowed as much ... as expected”.

King will also give us the Bank’s new inflation forecasts. These will doubtless show inflation is on target to be at 2.5% (on the existing RPIX measure) in two years. But it should also say that at a time when spare capacity in the economy is limited, rising demand increases the risk of inflation overshooting.

There will be more of that, as I say, this week. In the meantime the big questions are these. How much further are rates going to rise? How long will they stay at higher levels? And what will be the consequences, particularly for heavily indebted households? Let me take these in turn. In the past 20 years or so there has been a series of peaks in interest rates, interspersed with mini-peaks. As inflation has been brought under control, so the height of these peaks has fallen. A 17% rate peak shortly after Margaret Thatcher’s government took office represented the modern high for interest rates.

She was as disappointed as anyone that 15% rates were required at the end of her term. The trend, however, was clear, as is the fact that the most recent peak for rates, 7.5% in 1998 (a year after Bank independence) was half that a decade earlier.

Not only has the level of rates come down, and thus the peaks, so has the extent that rates have had to be raised in each period of tightening. A year or so before rates went to 15% in 1989, they stood at 7.5%.

Nothing like a doubling of rates has been required since. Britain’s “new” monetary policy began in the autumn of 1992, out of the ashes of Black Wednesday and the exchange- rate mechanism, when the Bank was given the job of publishing quarterly inflation reports and publicly advising the chancellor on interest rates. The second phase, of course, came in May 1997, when the Bank was given control over rate decisions.

In the 11 years of “new” monetary policy there has been one major interest-rate peak, the 7.5% level reached in 1998, but there have been three distinct tightening cycles. In the first, in 1994-95, rates rose from 5.25% to 6.75%. The second, in 1997-98, produced a rise from 6% to 7.5%. The most recent, in 1999-2000, produced the smallest trough to mini-peak increase, from 5% to 6%.

This bit of recent history gives us a good feel for what might be in store. We shall do well if the rate rise is confined to a percentage point, as in the most recent cycle. By the same token it would be disappointing if a rise of more than 1.5 percentage points was needed. Rates will peak this time, I would judge, at between 4.5% and 5%. If pressed, being of a dovish disposition, I would hope 4.5% will be enough.

How would this square with what should be a normal or “neutral” level in Britain? The impending change of inflation target complicates it slightly but a neutral level of rates is two to three percentage points above inflation. Rates of between 4.5% and 5%, in other words, could be thought of as neutral, while the new 3.75% rate is below normal, as the Bank had to take emergency action to steer the economy through global weakness.

How long will it take to get to the new rate peak? The “new” monetary policy period has been characterised by long periods of inactivity, between which the MPC moves quite fast. When it decides to change rates it does not hang around. On average it takes a year for rates to move from trough to mini-peak, although as analysts at 4Cast note, the first percentage point of any rise has usually been accomplished in about six months.

A rise in rates of the kind outlined above should not cause undue concern. The boom in borrowing and house prices in recent months has been too strong for the Bank’s comfort, but it is still hard to see a return to the distress of the early 1990s. House prices in London and southeast England, which have been most vulnerable, are now getting renewed support from rising City bonuses.

It is worth remembering, too, when you hear dire warnings of the consequences of 5% interest rates, that before September 11, 2001, rates had not been as low as 5% for three decades. Despite 900 billion of household debt, servicing costs would remain lower than in the late 1990s.

All this sounds, therefore, a remarkably benign prospect. What could go wrong? There are a couple of things that could give us far higher rates. The new monetary policy period has been unusual in that rate decisions have been taken calmly in the light of the latest evidence. This contrasts with the rate panics of the past, usually the result of a sterling crisis. There is no sign the pound is about to succumb to frenzied selling but if it did, the rate outlook could change dramatically.

It could also change if I am wrong about inflation. Perhaps the recent outbreak of industrial unrest tells us something. Maybe the economy is so close to capacity that the global upturn, combined with continued public-sector expansion, will tip us into significantly higher inflation.

On the other hand, it could be that the global economy is flattering to deceive. A terrorist attack, an American economy that runs out of steam, a big stock-market fall, could mean that rates don’t need to rise much further, and could even fall next year. Those outcomes are possible but not likely. For everybody’s sake, the benign middle course is best.


PS: A few years ago I wrote a book, Eurofutures, in which I said there was a 30% probability that monetary union in Europe would not survive. The response, particularly from audiences in Europe, was that this was some crazy eurosceptic delusion.

My argument was that countries would not put up with the fiscal discipline and that populist politicians would emerge to urge withdrawal. We haven’t reached that point, not least because Europe is bending the rules — the stability and growth pact.

Wondering about a euro break-up, though, is no longer such a lonely occupation. The German bank WestLB puts the chances over the next five to eight years at 15%. Germany, it says, would be most likely to head for the exit first.

I pass this on not to encourage it to happen. Whether or not the euro was a good idea, a break-up could hurt Britain. Maybe Jean-Claude Trichet, the new European Central Bank president, will be so good that the question no longer arises.

From The Sunday Times, November 9 2003

Comments

Hello Dave and thanks for opening the weblog.

Well the BoE inflation report came, sounded bit hawkish but since RPIX will be phased out to the HCIP in the near future, there's somewhat limited value and insight to thinking of the board. Personally I think the "harmonised" statistics are garbage a'la creative accounting Enron-style, but this true to the Noo Lapour form. Plus politically this is a true win-win for the troubled Chancellor, chance to halve the inflation rate in the country by stroke of pen and gearing up the GBP for eventual EUR entry (now some commentators say Gordie Brown is dead opposed against the EMU entry, however I believe this only applies when he is the Chancellor. If he would take over the as PM , then again ... )

Anyways, us City folk been marvelling the reaction of Short Sterling (ie. the interest rate futures, which predict the future rates) lately, as the market is pricing now 5.0% by Sep-Dec 2004, guaranteed. Now this full +100bp of hikes, which would set the pace to approx 25bp per quarter and seems more or less in touch with the age old "lets look at what happened in last cycle" method. Farther to the 2 year part of swap curve , markets are pricing even more hawkish picture...

Now I tend to agree with your more dovish view of things , since I still think the US economy is experiencing "statistical recovery induced by unseen levels of stimulus". I doubt very much the growth is going to be sustainable and equity market valuations are extremely optimistic. US markets generally set the trend and any weakness there will be reflected at our side of the pond too.

Second, I think the British consumer has dug himself into a very DEEP hole by overborrowing on the mortgage and consumer credit side. The net disposable income of private sector workers has moved very little and the picture is getting gloomier with Neuerarbeitspartei running into deficit land and will be probably forced to push the ever increasing tax burden even higher. Steep increases in the base rate would truly hurt the consumer more now than say back in '80s as the indebitness is far more reaching this time and greater sums have been borrowed.

Third then, as always the bane of BOE has been the Sterling. Sterling has rallied heavily against the USD during this year, thereby making commodities inputs (all priced in USD) cheper. And the continuing dollar weakness seems to be running trend in the market. I cannot see a Sterling crises around the corner as majoirity of trade is within the eurozone and GBP does have a quite strong correlation with the EUR.

So all in all, I tend to agree with your prediction for 4.0% to 4.5% reached sometimes next year...

Posted by: Front4uk at November 12, 2003 10:11 PM

Front4UK,

A slight correction to your statement "majoirity of trade is within the eurozone". This is a common Europhile twisting of the truth.

Of our export trade that goes into the northern European sea cargo terminals, approx 50% stays on the boat to complete its journey to its destination outside the EU.

However, the Europhiles pretend that this is an "export to the EU" to boost their figures, even though it never touched dry land.

Posted by: Ron at November 13, 2003 12:30 AM

Very good reminder of the much more narrow range of reasonably expected parameters, some plus minus 20-30% variation rather than 100%. This victory for monetarism should prolly mean that fiscal effects are more important. But perhaps, too, the effects of rules and paperwork overhead may be an undercovered problem?

Posted by: Tom Grey at December 27, 2003 07:04 AM
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