Sunday, July 23, 2006
Time for steady nerves on rates
Posted by David Smith at 11:00 AM
Category: David Smith's other articles

There was panic, if not in the streets, then at least in City dealing rooms. The release last week of figures showing a jump in consumer-price inflation from 2.2% to 2.5% — above the Bank of England target of 2% and equalling the highest rate since the series began in 1997 — was widely seen as a green light for higher interest rates.

Some even believe that the Bank’s monetary policy committee (MPC) has tarried too long. By keeping base rate at 4.5% while other central banks have been raising their rates, could it be that the Bank is, in the jargon, “behind the curve”? August has become a popular month for rate changes. Last year the MPC cut by a quarter point to 4.5%, reversing its move a year earlier. There would be a neat symmetry in putting rates up next month.

The case for a hike is easy, almost effortless, to make. Not only is inflation above the target and likely to rise further, but global economies look healthy. Britain grew at an above-trend 0.8% in the second quarter, its fastest for two years, manufacturing is picking up and the housing market looks robust, with gross mortgage lending hitting a record £32.2 billion last month.

Retail sales were strong in June, up 0.9%, partly on World Cup spending but enough to guarantee a good second quarter. The money supply, M4, is growing by nearly 14%, though this is driven by lending to financial firms and may not be telling us much.

Outside Britain, Europe is picking up and the world economy is still booming. Growing signs of a slowdown in America are balanced by China’s growth, 11.3% year-on-year in the April-June quarter. The Bank has an interest-rate weapon at its disposal. Isn’t it time to use it?

The one place where there wasn’t much panic last week, however, was in the Bank itself. That was evident in the minutes of its meeting earlier this month, when the depleted MPC voted 7-0 to keep rates on hold and emphasised both upside and downside risks to inflation. But it was also true after the release of the inflation figures, which came in roughly as the Bank had expected in its May economic forecast and were thus not regarded as shockers.

Inside the Bank the view is that inflation has been extraordinarily stable, particularly in the light of the kind of energy price increases seen over the past three years. The MPC, far from being behind the curve, was ahead of it, raising rates two years ago, long before the Federal Reserve, the European Central Bank and Bank of Japan.

There is also satisfaction verging on wonderment about the behaviour of pay settlements. Higher growth in wages would be the main indication that “second-round” effects from higher oil, gas and electricity prices were feeding through. But wages remain superbly well-behaved. Average earnings growth, excluding bonuses (the best measure of underlying pay growth) is just 3.8%. Pay settlements remain well-anchored. As the Bank itself pointed out: “Settlements ... continued to be weaker than at the same time last year, and a little below expectations.”

Some in the Bank are unhappy that the inflation measure they are required to target, the consumer prices index, is viewed with suspicion by many people, because it excludes house prices as well as big elements of household spending like council tax. But it is the measure the Bank has to live with.

The target, moreover, is symmetrical. People get very excited when inflation creeps above the 2% target but are unmoved when, as has usually been the case, it is below it.

The Bank, as Sir John Gieve, one of its two deputy governors, pointed out last week, has discovered something interesting about inflation. When there is pressure from some sources, such as rising energy costs, it is offset by an apparent reduction in price pressures elsewhere, keeping inflation close to target. If companies know their customers are being squeezed by high oil prices, for example, they take the hit on their margins.

The Bank’s calmness does not mean interest rates will not rise, even as early as next month. The City has been on a rollercoaster, the inflation figures heightening expectations of an August hike, the MPC’s minutes reining back expectations, before strong retail sales, M4 and growth data pushed them up again.

It is a tough decision. The case for a hike is easy to make. But what about the case for not raising rates? For me, this is based on three things. “Core” inflation, excluding energy, food, alcohol and tobacco, remains low at just 1.2%. Excluding just energy, inflation is 1.4%.

Wage settlements, as already noted, are very low, with no hint they are heading higher, despite rising cost-of-living pressures. The key months for pay settlements — January and April — are some way away, suggesting the MPC has plenty of time should it need to fire a warning shot across the bows.

The big question, however, is how to treat the rise in energy prices. Should we treat it as inflationary; a powerful reason for the Bank to act? Or are higher energy prices in the absence of second-round effects a tax on consumers and businesses? Are they, in other words, doing the MPC’s job for it?

The Ernst & Young Item Club, in its latest economic forecast, to be published this week, says that Britain’s economy has enjoyed “seven years of plenty” thanks to fast-rising spending by the government and consumers. But an awful set of figures for the public finances last week, with net borrowing at £16.4 billion over the April-June quarter, up by £3.4 billion on last year, has underlined the need for a sharp slowdown in public spending. I shall return to Gordon Brown’s problems in this area soon.

For consumers, the problem is of the irresistible force of rising energy prices meeting the immovable (so far) object of low wage settlements. Disposable incomes are being squeezed. You wouldn’t know it from the recent retail sales figures, but we soon will. A further squeeze on households through a rise in mortgage rates may be unnecessary. It could also be counterproductive, if some workers saw it as the straw that broke the camel’s back and pushed for bigger pay rises.

There is also the clear possibility, showing in a number of leading indicators, that the world economy will slow significantly in the coming months, in response to the global tightening of monetary policy.

In short, the Bank can afford to wait. This is a time for calm nerves and steady rates.

PS: I’ve noted before important parallels between the two key initiatives aimed at fostering European integration; the EU and the Eurovision song contest. In each case, what started as a cosy club of a few countries has spread out. In each, Britain doesn’t get much of a look-in.

Now I’m glad to report some serious research on Eurovision, published by the Centre for Economic Policy Research. It is “Love Thy Neighbour. Love Thy Kin: Strategy and Bias in the Eurovision Song Contest”, by Sofronis Clerides and Thanasis Stengos (who sound a bit like a Eurovision double-act).

You may think Eurovision is ridiculous, but as the paper points out, it has lasted 50 years and has a potential television audience of a billion. After analysing voting patterns for the period 1981-2005, the economists prove what we suspected — the best song doesn’t usually win.

As they put it: “Differences in voting patterns ... reflect deeper sociological likes and dislikes among nations that manifest themselves in systematically biased voting.”

Those biases have got worse since telephone voting by the public was introduced. We are only talking about songs, but what if Europeans voted on EU-wide policy matters? And, as for Britain’s poor showing, we can only draw comfort from the slogan of Millwall football fans: ‘No one likes us, we don’t care.’

From The Sunday Times, July 23 2006


No matter what, raising interest rates is never the answer is it David? I note your predictions for inflation have been way off of late, as they have been been for oil.

The bank has a inflation target. Inflation goes up, then the repo rate goes up. Simple.

I understand that you are contemplating future moves in interest rates as justification for your argument. But then again, you have been unsuccessful of late in managing this.

Have you become blinded to the upside inflation risk? Your recent performance suggests it is.

P.S. I don't want to hear the no-one else predicted this excuse.

Posted by: Sinhale Shah at July 23, 2006 01:12 PM

The Bank, as Sir John Gieve, one of its two deputy governors, pointed out last week, has discovered something interesting about inflation. When there is pressure from some sources, such as rising energy costs, it is offset by an apparent reduction in price pressures elsewhere, keeping inflation close to target.

What a surprise, even though it seems inflation is spiralling out of control and the cost of living increasing hugely on a daily basis, the CPI basket magically comes in right on target. Not that it's rigged or anything, Brown would never do something like that, being our best chancellor ever and all.

Posted by: bah at July 23, 2006 03:47 PM

Quote. "The bank has a inflation target. Inflation goes up, then the repo rate goes up. Simple." .... And economically literate.

(a) Monetary policy operates with a long lag. What matters is not inflation now but what the Banks expects it to be in 18-24 months time.

(b) A big rise in oil prices was the very situation when it was envisaged, not only that inflation would go above target, but that it would go outside the letter-writing range. The surprise is not that inflation is high, it is that it is so low.

(c) As everybody forgets, the target is symmetrical. A couple of months above target, after years below it, and everybody starts running round like headless chickens.

Posted by: David Smith at July 23, 2006 04:05 PM

I'm fascinated then to know what you think lies ahead for European integration after Lordi's Eurovision win this year. Mind you there was that piece on the BBC website about how we should all be more like the Finns.

Posted by: Jonathan at July 23, 2006 06:34 PM

Quote. "The bank has a inflation target. Inflation goes up, then the repo rate goes up. Simple."

I don't think those who understand MPC policy will disagree that they primarily have an inflation target. As a result, higher inflation figures will translate at some point to a higher repo rate.

As usual the argument boils down to what one believes inflation will do over the coming months. David, I do feel that you underestimate the dark side of the force and that inflation will climb higher. Our abnormally lax base rate world seems to be tightening up all around us, and I'm fairly certain we won't escape the noose so easily. Well, I guess only time will tell...


It can't be easy David to put predictions in print and face the criticism when we don't get things right, particularly on a national level. But well done for having the gall to put your ideas on paper. I don't always agree with what you've written, but then it does provide food for thought.

Posted by: Werewolves at July 24, 2006 12:28 AM

Interesting to see the ITEM club argees with David (Or David Agrees with them

Despite inflationary risks from high oil prices, the report said there was 'probably enough slack in the UK economy' to allow the Bank's Monetary Policy Committee to keep its base rate at its current level of 4.5%.

While inflation reached 2.5% last week, the Item Club said the figure was likely to fall below its 2% target from the middle of next year and average 1.8% in 2008.

Posted by: Kingofnowhere at July 24, 2006 08:32 AM

There is very little case for raising rates.

Firstly there's the massive risk to the housing market which has been foremost in the MPC's thoughts since last year's August cut to bring about the soft landing. The plates are still spinning and there's work to be done still!

Also there's the World Cup effect which skews the inflation figures. I know that in the run-up to England vs. Ecuador match, I rushed out and bought a new car, and a loads of those little England flags. It's paramount that these impluse purchases are not included in the equation.

Posted by: Grahame Woolfson at July 24, 2006 09:37 AM

HI David

Seems moneyweek think your only reason is that the BOE hasn't prepared the markets. Doesn't Merryn Somerset Web write in the Sunday times, I would have thought she would have read your articles? Perhaps not, because shes been predicting a house price crash since 2002 ;)

And indeed, the only reason that The Sunday Times could find for the Bank not to hike rates is "because it has not prepared the markets to do so."

Posted by: Kingofnowhere at August 2, 2006 11:04 AM

Didn't work out too well for you there, did it David? Rates up!

Posted by: Borat at August 6, 2006 10:45 AM

Thanks to Borat for bringing us the news of the rate rise. I think it's called stating the b***ding obvious.

As I said in this piece, the case for a rate rise was an easy one to make. The case against was more subtle, and it went beyond the fact that the Bank had not prepared the markets. On this occasion the Bank went for the unsubtle approach. It won't do any serious harm, though the handling of it has done nothing for the Bank's reputation.

Posted by: David Smith at August 6, 2006 12:17 PM