Sunday, November 12, 2006
Bank takes us up to a higher peak
Posted by David Smith at 11:00 AM
Category: David Smith's other articles

So 5% it is, and nobody can have been surprised. Taxi drivers were telling me that interest rates were about to go up and window cleaners were whistling it. Unlike in August, when the red faces all round were not the result of the summer heat, this one was perfectly signalled.

What does it portend? One interesting aspect, to me at least, is that Thursday’s rise breaks an important sequence. Compared with the great snow-capped interest-rate peaks of the past, when we reached the giddy heights of 15% or 17%, recent highs have been very modest, mere foothills by comparison.

But even those foothills have been getting lower. The first peak after Bank of England independence in 1997 was 7.5%, after which there was a fall all the way to 5%.

The next peak in Bank rate was 6%, and the subsequent fall, which embraced the response of the monetary policy committee (MPC) to the effects on confidence of the 9/11 attacks on America, took the rate down to just 3.5%.

The following peak, 4.75%, was reached in August 2004. Whatever happens from now on, that peak has now been exceeded. Purists might argue that quarter-point rate reduction in August 2005 did not constitute a proper rate cycle. But it happened and it tells us something important.

This is that we have passed the point where interest rates can go ever lower. In the first few years of Bank independence it seemed that rates would keep going down, but there had to be a limit.

Most economists would put the “neutral” rate of interest in Britain at between 4.5% and 5.5%. By that I mean the level at which monetary policy is neither stimulating nor restraining the economy.

This does not mean we will never move out of that range, in either direction, should the Bank feel the need to stimulate a tired economy or put out an inflationary fire. But it does mean that we are now slap bang in the middle of what can reasonably be regarded as the normal range for the Bank rate.

It is interesting, in this context, to compare Britain with Europe. With the exception of Austin Mitchell, the veteran Labour MP who writes to Mervyn King ahead of each MPC meeting calling for lower interest rates, Thursday’s rate rise passed without a political murmur.

Some European finance ministers are, however, already concerned about “overkill” from the European Central Bank with its key interest rate at 3.25%, and set to rise to 3.5% next month, having risen from a low of just 2%.

Why are European interest rates lower than those in Britain? I used to argue that it was because of the different inflation traditions and tendency towards over-exuberance of the UK housing market.

Now there is a rather more straightforward explanation. After several years in which Britain’s inflation rate was below Europe’s, there has been a shift. Measured on the same basis, consumer-price inflation is 2.4% here, against 1.6% in euroland. UK inflation is about to go higher — the introduction of the new, higher university tuition fees being the culprit — suggesting that it will soon be at least a full percentage point higher than in Europe.

Does this mean the Bank of England has lost the plot and, like the tortoise and the hare, the slow-moving European Central Bank is now doing a better job? After a bad start, the ECB, under its president Jean-Claude Trichet, is winning plaudits for transparency — that is, for not springing unwelcome surprises. The Old Lady of Threadneedle Street, by contrast, lost brownie points for transparency by wrongfooting the City three months ago. Under Trichet’s predecessor, the late Wim Duisenberg, the ECB appeared to take pride in being opaque.

It would be wrong to blame the Bank too much. Apart from the coming impact of tuition fees, most of the inflation difference between Britain and euroland is explained by energy; “core” inflation measures excluding energy and seasonal food are similar (1.6% UK, 1.5% euroland).

This, in turn, is due to two things. Excise duties on petrol in Britain are among the highest in Europe. This means that when crude oil prices fall, as they have recently, the effect on pump prices is more muted than in other countries — both Europe and America (which also has a lower headline inflation rate than Britain) have benefited from this. By the same token, however, this muting effect should have applied on the way up, so there is an element of swings and roundabouts.

There are also big differences when it comes to domestic energy prices — gas, electricity and heating oil. They rose less in Europe than in Britain on the way up — typically half to two-thirds as much — and have fallen more quickly in response to changing energy-market conditions. Are Britain’s consumers being fleeced by gas and electricity suppliers? The statistics suggest that they are.

The big question left by Thursday’s decision to raise Bank rate to its highest level since September 2001 is where it goes from here. The MPC’s task is a delicate one. It has to convince people, particularly wage bargainers over the winter months, that it is vigilant. But it also has to keep interest-rate expectations reasonably well anchored.

Its statement after the rate rise said that it was “necessary to bring CPI inflation back to the target in the medium term”, implying that its job may be done. Many in the City, however, expect a rise to 5.25% in February, and perhaps even further increases later.

We will know more this week when the Bank publishes its quarterly inflation report. The last one, in August, signalled that a 5% rate would indeed be enough to achieve the 2% inflation target. The short-term inflation picture has improved since on the back of falling oil prices, although MPC members have been quick to warn it does not remove the danger.

The answer is that it depends, and it depends particularly on the labour market. Goldman Sachs points out that while pay pressures have been contained, firms have faced a sharp increase in non-wage employment costs over the past couple of years — largely higher National Insurance contributions and pension costs.

Wages, however, are what the Bank will be looking at. There were many reasons for Thursday’s rate hike but one of the most important was that it was a shot across the bows for pay bargainers (although it will have the effect of pushing up the closely watched Retail Prices Index even further).

If it works, and pay settlements remain benign, we may get away with 5% as the peak, and certainly no higher than 5.25%. If not, it could be time to get out the cold-weather mountaineering gear.

PS: Among the many things for the MPC to mull over in the coming weeks will be the housing market. Prices rose by a perky 1.7% last month, according to Halifax, and were up by 8.6% on a year earlier. Martin Ellis, Halifax chief economist, detects signs of a slowdown in house buying and predicts that house-price inflation will ease back in the coming months.

Let us hope so. Five-times-salary mortgages and loans of 125% of property value have grabbed the headlines. The City has had a great year, and estate agents in London and southeast England are no doubt rubbing their hands at the prospect of well-heeled buyers with fat bonuses.

But published evidence of a slowdown is not easy to find. The Royal Institution of Chartered Surveyors backed Thursday’s rate rise, although estate agents are frustrated by declining numbers of properties coming onto the market. The Council of Mortgage Lenders says it expects continued robust levels of lending over the coming months.

Lenders and surveyors are united, however, in expecting slower house-price growth during next year, partly as a result of higher mortgage rates and partly because of factors such as the squeeze on household incomes as a result of dearer energy. As I say, let’s hope so, although it has to be said that most people, myself included, underpredicted the strength of the housing market this year.

From The Sunday Times, November 12 2006