Sunday, June 12, 2005
How big a rate cut do we need to get moving?
Posted by David Smith at 11:00 AM
Category: David Smith's other articles

THE other day I was in a shopping centre. Rubbing my eyes in disbelief, I found that not only was it quite crowded, but people were spending money. Some were even using credit cards. You may have had a similar experience.

Lest that sounds as though I should get out more, I should explain that retailers have taken to wondering gloomily whether they will ever again hear the jangling of tills, or perhaps I should say the “beep” of Pin numbers being entered.

Is my experience consistent with last week’s warnings of a “consumer-led recession”? Kevin Hawkins, director-general of the British Retail Consortium, said last week that the latest survey from his organisation removed “any lingering doubt” that the economy was being dragged into the mire by reluctant shoppers.

Perhaps, though, Helen Dickinson at KPMG, which sponsors the survey, put her finger on it when she noted that while May 2004 was warm and sunny, last month the sun appeared only sporadically. The better weather, for at least a few days last week, explained the sightings of flocks of lesser-spotted shoppers.

So it is too early to say there is a consumer-led recession, and I don’t believe that is the way we are heading. But something has changed. Strip out the weather and it is still the case that retail-sales growth (and the wider consumer-spending measures) have slowed decisively. Consumer spending grew by 3.3% last year, but will struggle to reach half that this year. In recent years a typical growth rate has been 4%.

The housing market has also slowed. Bad news is more interesting than good, so when the Halifax reported that house prices had fallen 0.6% last month it generated more column inches than Nationwide’s observation that prices had risen 0.3% over the same period. For those who remain on crash alert, Halifax’s figures were grist to the mill.

Halifax’s fall owed something to seasonal adjustment; the unadjusted average house price rose from £163,428 to £164,242. But all the house-price measures are telling us essentially the same thing. Prices have stagnated. House prices have been flat since July. They are not crashing but are certainly not rising.

The interesting question is why this is happening. Most of the big numbers for the economy are still positive, most notably employment. Real incomes are growing, albeit a bit more slowly than they have been. But suddenly people have become more reluctant to take on extra debt and, in the case of credit cards, keen to repay some of it.

That may be because some of the warnings about insufficient savings and too rapid a build-up of debt have hit home. More likely it is because, as Royal Bank of Scotland noted in its trading update last week, consumers are reining back because of higher interest rates.

The decisive response of consumer spending and the housing market to just five quarter-point interest-rate rises, and what now looks clearly like a base-rate peak of 4.75%, is really rather interesting. It implies an interest-rate sensitivity among households far greater than in the past, when draconian increases were often needed to get through to consumers. The Bank of England’s monetary policy committee (MPC), which last week predictably left the rate unchanged, has a subtle as well as a powerful tool in its hands.

Assuming the next move is down, this will continue a sequence in which each successive interest-rate peak is lower than the one before. The Bank’s first post-independence rate peak in 1998 was 7.5%, followed by 6%, and now 4.75%.

This raises another question. I have written here before of the “neutral” rate of interest, the level of rates that neither restrains nor stimulates the economy. The rate consistent, in other words, with economic growth in line with the long-run trend and inflation on the 2% target.

Before the present sequence of rate rises was completed last August I had thought the neutral rate was in the 4.5%-5% range, which is where we have ended up. Others, notably Paul Tucker of the MPC, thought it was slightly higher, at 5%-5.5%.

Some economists believed (indeed, some still believe) that much higher rates would be needed. Tim Congdon of Lombard Street Research thought that 6% was necessary. This was not so much a difference of views over the neutral rate but the belief that rates would need to go significantly above neutral — as has often happened in the past — to produce the desired slowdown effect. In Congdon’s case the argument was that higher rates were needed to produce a slowdown in money-supply growth.

So what does the economy’s performance in response to higher rates tell us? Either that the Bank tuned things to such perfection that all that was needed was neutral rates to slow down the economy, or, in fact, the current level of rates is above neutral, in which case the next peak will be lower still.
Is there a good reason why interest rates in Britain are so much higher than in America, Europe and Japan? The stock answer would be that the British economy is closer to capacity than others and needs higher rates to prevent inflation taking off.

An important subsidiary explanation, however, is that higher rates are a legacy of past inflation. There remains, in other words, a suspicion that Britain could return to the bad old ways. Because of this the “real” interest rate — the gap between base rate and the inflation target — has to be something close to 3%.

Surely, however, that is no longer valid. Twelve years of low inflation and the Bank’s successful record have bought a lot of credibility. UK rates should no longer have to include a premium for previous inflation excesses; 4.75% — which would have been regarded as extraordinarily low even a few years ago — now looks too high. And perhaps the neutral rate, if not as low as the European Central Bank’s current 2% base rate, should be closer to 4%.

We may soon see. On present evidence, rates should be down to 4% next year, with the first cut perhaps in the late summer. For retailers, despite some sunny weather, that may not be soon enough.

PS: It took a little time to generate a response but some people think I have been a little hard on the euro. They point out it has been a useful counterweight to the dollar, particularly in the development of euro- denominated bond markets. It has also, unlike most previous failed monetary unions, got the important underpinning of a central bank.

But the tectonic plates have shifted. An excellent paper, “EMU at risk”, from the Centre for European Policy Studies (CEPS) in Brussels, describes the dilemma well. On one side is the risk of “lira-isation” of the euro as the European Central Bank is forced into over-expansive action. On the other is the danger of withdrawal by some members.

After recent excitement I have not changed from the view expressed here two weeks ago. This was that the euro would be around in its present form in a year’s time but, barring an improvement in Europe’s economic fortunes, probably not in 10 years.

These things, however, do not always go according to plan. Last week the European Commission insisted the euro was “for ever”. I remember John Major saying something similar about Britain’s membership of the European exchange-rate mechanism six days before that came to a sticky end.

If enough people believe the euro will not survive in the long term, the long term becomes the short term very quickly. We are not there yet. But the euro’s economic foundations need shoring up. An early cut in interest rates, notwithstanding the CEPS’s warning, might help.

From The Sunday Times, June 12 2005


Inflation figures for May are just out. Although CPI stayed unchanged below target, RPIX fell.

Now that we’ve passed the big inflation months for the year it’s unlikely there will be any shocks in the figures for the rest of the year. Plugging in average monthly values for RPIX only takes us to a high of 2.4% in Sept. then back towards 2.0% by the end of the year.

The big question now is how retailers will behave in the July sales. Are they loaded with stock that they’ll have to dump at low prices or have they seen this slowdown coming, unlike January?

Mervyn King gave an interesting speech yesterday:

In one of his Maradona-style head-fakes he tried to confuse us with a cricket analogy. But I couldn’t see any sign of a swerve towards rate cuts. My guess is that the August inflation report will show inflation staying close to target with no justification for a cut. It’s interesting that he’s ignoring the cries of retailers and pinning his hopes on services - or the nail-decorating industry, as I like to call it. Oh that we’ve come to this.

Also, with the dollar rising and the oil price staying high it’s not clear why retail prices should fall anyway, even with a retail slowdown.

Finally, another governor gave a speech today – Ian Macfarlane of the RBA on “Global Influences on the Australian Economy“:

It’s interesting he makes the point twice that we’re at an “early stage of the global expansion”. Let’s hope so.

Posted by: David Sandiford at June 14, 2005 11:42 AM