Sunday, May 15, 2005
Interest rates at the crossroads
Posted by David Smith at 11:00 AM
Category: David Smith's other articles

The big story of the week was the Bank of England’s change of tone on interest rates. Its latest inflation report does not signal an imminent cut in rates, as some suggested, but it does mean that a hike has now all but disappeared from the agenda.

More on that in a moment. This week’s minutes from the May meeting of the monetary policy committee (MPC) will be fascinating. Two members have been voting for higher rates: Paul Tucker and Sir Andrew Large. Any sign that they have changed their minds, or are in the process of doing so, would reinforce the Bank’s new dovishness.

The Bank’s inflation report is important because, as noted last week, it holds the key lever of economic power, interest rates. But its publication is also an occasion, one of the few in Britain, when policymakers put themselves up for detailed questioning by economics journalists. Mervyn King, the governor, has been presenting the report each quarter since it came into being, under his direction, in 1993. He doesn’t usually put a foot wrong.

In contrast, and this might surprise you, neither the chancellor nor his senior officials submit themselves to such detailed questioning by specialist journalists after big Treasury events such as the budget or pre-budget report. The nearest the Treasury gets to it is an impromptu official briefing for lobby journalists in the Commons press gallery as soon as the chancellor sits down after making an important statement.

It hasn’t always been this way. I remember when Sir Peter Middleton and Lord Burns told a small group of us one Friday afternoon in October 1990 — after the markets had safely closed — that Britain would be entering the European exchange-rate mechanism the following Monday.

Gordon Brown summoned everybody to the Treasury a few days after the 1997 election to break the news of Bank independence from Treasury control. At first the penny didn’t drop. The first question, from a television journalist, was: “You’ll be sitting on this new monetary policy committee, and presumably your deputy will, too. But who else will be on it?”

So the Bank’s openness, for an organisation that used to be as closed as the freemasons, is very welcome. What did we learn from the Bank last week?

The first thing is that, after poring over the data and reports from its agents round the country, it cannot quite work out whether the recent weakness of consumer spending is temporary — following the example of America, which produced an unexpectedly strong bounceback in retail sales last week — or likely to be long-lasting.

Despite near suicidal reports from retailers, and the depression of much of the consumer sector, this is not yet armageddon. Consumer confidence has not collapsed. All that has happened is that people aren’t spending so much. There could be an innocent explanation for this — the weather, the timing of Easter, even the general election — or it could be rather more sinister.

The Bank’s inclination is that spending will pick up, though at a slower rate of growth than it previously expected. But it admits to doubts. “It is also possible that the deceleration in house prices and the cumulative impact on highly indebted households of past increases in interest rates may be associated with a more prolonged slowdown,” the inflation report said.

It has no such doubts about the outlook for government spending. After an election campaign that included a bizarre kind of beauty contest, based on whose pledges were the biggest, the Bank thinks public spending will continue to “grow strongly” in the coming years.

What is the effect of that? “The public sector can contribute to inflation by using resources that would otherwise be employed in satisfying private-sector demand,” it says. “Given the government’s nominal spending plans, its demand for resources is likely to grow quite quickly during the next few years.” It is a coded message but what it means is that the chancellor’s largesse will lead to higher inflation and interest rates than would otherwise be the case.

It could also, if the gloomier alternative for consumer spending turns out to be true, mean that public spending will be just about the only thing growing strongly.

The best the Bank can say about exports is that, after nine years in which their growth has been easily outstripped by imports (in the jargon, net exports are negative), their contribution may be slightly less negative in the future. That’s a long way from the export-led growth that chancellors dream of.

Nor is there much investment-led growth. Business investment is picking up, but at a slower rate than in previous recoveries. There may be a statistical explanation for that but it chimes with anecdotal evidence, which is that firms remain reluctant to spend heavily.

Where does that leave the economy and interest rates? One of the features of the Bank’s running of monetary policy in the past eight years is that consumers have been grateful recipients of interest-rate cuts. Often those cuts have been due to events outside Britain, such as the September 11 terror attacks or the uncertain global economy at the time of the invasion of Iraq. But the aim has been explicit, to keep consumer spending going in order to compensate for weakness elsewhere.

What happens, though, if the weakness comes from consumers themselves? If spending continues to be depressed over the summer months, past experience would suggest that a modest cut in interest rates in the autumn would be enough to perk up shoppers in plenty of time for Christmas.

But what if something more fundamental has changed and that, in response to a flat housing market, high levels of personal debt and worries about higher taxes, jobs and pensions, the reluctance to spend goes deep? It could be that in these circumstances big cuts in rates would be needed to shake consumers out of their torpor. Even then, as discussed here two weeks ago, we could be in for a prolonged period of subdued spending. The housing market is not, I think, going to spring quickly back to life.

Interest rates, then, are at a crossroads and the most likely route ahead will be flat for quite some time, followed by a drop downhill. Consumers hold the key to when that dip comes, and how steep it is.

PS: Sipping my Horlicks the other evening after a day spent mulching the roses, I began to wonder whether I am getting old. When shop assistants call you Sir without apparent irony you get worried. It can only be a matter of time before a heavily pregnant young woman offers me a seat on the Tube.

My musings were sparked by the post-election job shuffles. George Osborne’s relative youth, 33 going on 34, has been much commented on. I am used to shadow chancellors being father figures, not callow young men. Let’s hope for the Tories’ sake he turns out to be a baby-faced assassin.

That was not the only injection of youth. Brown’s new crop of special advisers and press spokesmen are in their late twenties and early thirties. Pretty well all their adult life has been under Labour.

Most of all I was struck by the tumultuous (if not spontaneous) welcome the chancellor got on returning triumphantly to the Treasury after the election. The gathered ranks of applauding young officials, dressed in polo shirts and chinos, looked like a university golf society outing. Some of the Treasury’s crustier former mandarins, who never entered the building without a suit, starched collar and tie, will have been turning in their graves.

From The Sunday Times, May 15 2005


All very well, except that the consumer might be MEWed up to their eyeballs and unable to squeeze anything more out of their bank manager because house prices just stop going up.

Barclays has just released an RNS saying that "delinquency" of its credit card debt has hit a peak.

This suggests the downturn in consumer spending may be rather more serious than you suggest. If you look at recent annoucements, its all big ticket discretionary items that have been hit: Dixons, Jessops, Kesa and JJB (noone really needs a replica football top).

It also suggests interest rates will come down.

Posted by: Paul at May 27, 2005 05:21 PM

They will come down - the question is how long will it take. There's an interesting speech from Steve Nickell of the MPC today (May 31) saying there is more spare capacity in the labour market than has been assumed.

Posted by: David Smith at May 31, 2005 12:52 PM

Steven Nickell is right. The most common response to a job application in the private sector is "overwhelmed by high quality applicants".

Posted by: HJ at June 16, 2005 04:24 PM
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