Sunday, October 10, 2004
We've nearly scaled the peak
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

For a brief moment on Thursday, as I watched the seconds tick down to noon and the Bank of England’s interest-rate announcement, I wondered whether the nine men and women of its monetary policy committee (MPC) might surprise us all and announce a change.

What I was thinking was not that the Bank might give us a shock increase but that it would astound us with a cut. A flight of fancy? As it turned out, yes. The frisson of excitement came and went as the clock tolled 12. But the recent run of data has been relentlessly gloomy. Stranger things, moreover, have happened before. In the summer of 1998, when the Bank was still getting used to independence, it changed tack abruptly from raising rates in the summer to cutting them in the autumn.

As it happens, I do not expect the Bank to begin cutting rates any time soon. The MPC has worked hard to get base rate up to something approaching its “neutral” level, where it is neither pressing on the accelerator or the brake (last year’s emergency low of 3.5% being clearly below neutral). So it would think long and hard about another excursion into sub-neutral territory.

The more pressing question, however, and one that has been dominating discussion in the money markets, is whether the Bank will need to raise rates any more beyond the present 4.75%.

Before coming on to that, let us look at what the recent slew of weak data might mean. I commented in early September that the economy had hit a soft patch, with retailing, housing and manufacturing all showing signs of weakness. The global economic recovery appeared less robust, under the impact of oil then trading at just over $40 a barrel. Since then, there has been another month of weak data.

This suggests that the consumer and housing slowdowns reflected more than just the vagaries of the summer weather. True, the Halifax’s latest survey showed a 1.4% bounce back in prices last month but that seems an aberration. The same concerns about the world economy apply, and were voiced at last weekend’s G7 meeting in Washington, but this time at an oil price of $50 a barrel.

In shorthand terms, the economy has lost momentum because the consumer, its driving force for at least the last seven years, has pulled into a layby. Meanwhile, industry, together with parts of the service sector that rely on the strength of the global economy, is feeling the first draughts of economic winter.

After last week’s poor manufacturing output figures — the third successive monthly decline — the National Institute of Economic and Social Research estimated GDP growth in the third quarter to be a mere 0.4%, less than half the 0.9% rate officially recorded in the second quarter. Growth has slumped from well above trend to significantly below trend (trend is about 0.6% a quarter).

It seems likely that this period of slower growth will continue for a while. Not only were the manufacturing figures weak, but the latest purchasing managers’ survey for the services sector came in below expectations. The oil price refuses to lie down and will have a dampening effect on the world economy.

Uncertainty about the outcome of next month’s American presidential election will also hold back economic activity, although presumably there will be no repeat of the “tied” vote of 2000, when Americans stayed at home and the economy slid into recession.

So what does this mean for interest rates? My view has long been that the neutral interest rate was between 4.5% and 5%. We are there, the economy has slowed and inflation, at 1.3% on the consumer prices index measure, is below the 2% target and likely to remain so.

If I were on the MPC we would already have hit the peak in rates.

But I am not, and part of this job is to second-guess those who are. In August, when the Bank published its last inflation report, it gave a clear signal that base rate needed to rise a little more — to 5% or slightly higher — to meet the inflation target in two years. That was despite the fact that it also forecast a significant slowdown in growth.

That slowdown has been rather sharper than it expected, although sterling has also been weaker. The former eases the interest-rate pressure, the latter adds to it. Even so, barring a sudden return to robust health in the data, it is now hard to see the climate being right for the MPC to raise rates next month, as many had expected.

As for the following month, in more than seven years of independence the Bank has never increased rates in December. That should mean rates have risen for the last time in 2004.

What about 2005? Here views start to diverge. On one side are those, like Tim Congdon of Lombard Street and some other members of the “shadow” MPC reported last week, or Michael Saunders of Citigroup, who think the Bank has not done enough, that the pause will be temporary, and that the base rate will need to go up to 5.5% or more.
Lending support to their bullishness is the stock market, which appears to be looking through the present slowdown to stronger world growth next year.

At the other extreme are those who see current economic weakness as the shape of things to come, and predict that the MPC will soon be cutting rates. Thus, at the end of next year the base rate could be 6% or 4%. In the present climate that is quite a range.

We will know a lot more when the Bank publishes its next inflation report in November. Reading the runes, I would say there is significant but gradually diminishing chance of one more rise, to 5%, next February, followed by a prolonged rate freeze. The peak is in sight. We may already be there.

PS: I happened to be in Wales last week when Eurostat, the EU’s statistical arm, left it off the map, and the country appeared to be pretty solidly there to me. But, to prove all publicity is good, the controversy encouraged me to dip into Eurostat’s new statistical year book.

Britain does not, contrary to usual claims, have the biggest income inequalities in the EU. Spain, Greece and Portugal, also Lithuania and Estonia, are all more unequal. Mind you, we are one of the most crowded countries. Of the 15 members of the EU before May 2004, only Belgium and the Netherlands have greater population densities. For open spaces go to Finland’s frozen north.

Perhaps because of this overcrowding, there is greater sensitivity towards immigration. But Britain ranked well down the list of EU members last year for net migration, behind the likes of Germany, Italy, Sweden, Spain, Ireland and 14 countries (out of 25) in all.

The average British household, with 2.3 people, is smaller than anywhere else apart from Germany. But despite our generally successful labour market, a much higher proportion of children live in jobless households than in any other EU country. We also appear addicted to cheap food, spending less of our income on food and non-alcoholic drinks than elsewhere.

As for brain food, ministers insist we need to increase student numbers. But the Eurostat figures show in 2001 we had as many students in tertiary education as Germany, which has a population a third larger, and more than comparably-sized France, Italy and Spain.

And just to continue with the energy theme I have promised to return to, it is argued that renewable energy sources, such as wind, water and solar power, can never make more than a marginal contribution. That is certainly true in Britain at present. But renewables provide 15% of electricity across the EU as a whole, with 70% in Austria and more than 50% in Sweden.

From The Sunday Times, October 10 2004