Thursday, July 05, 2007
Bank hikes to 5.75%
Posted by David Smith at 12:15 PM
Category: Thoughts and responses

It would have been surprising if the Bank had not hiked rates, and this was one month where the monetary policy committee (MPC) chose not to surprise. I think (and hope) there will have been a significant vote against, but we'll see. Money and credit feature strongly in the statement.

This is what the Bank said: "The Bank of England’s Monetary Policy Committee today voted to raise the official Bank Rate paid on commercial bank reserves by 0.25 percentage points to 5.75%.

"In the United Kingdom, output growth has remained firm and appears to be evolving in line with the Committee’s most recent projections. Credit and broad money continue to grow rapidly. The pace of expansion of the world economy remains robust.

"CPI inflation fell back to 2.5% in May. Lower gas and electricity prices mean that CPI inflation is likely to continue to fall back to around the 2% target in the course of this year. Although pay pressures remain muted, the margin of spare capacity in businesses appears limited and most indicators of pricing pressure remain elevated.

"The Committee judged that, relative to the 2% target, the balance of risks to the outlook for inflation in the medium term continued to lie to the upside. Against that background, it further judged that an increase in Bank Rate of 0.25 percentage points to 5.75% was necessary to meet the 2% target for CPI inflation in the medium term."

Comments

may I ask why you wish, that there were a significant vote against a rate rise?

Posted by: Matt at July 5, 2007 12:44 PM

Dear David,
Although five interest rate rises (of 25 basis points each) since last August seem a lot, we have to see this (also) in the context of an uncertain inflationary environment (see e.g. succesive MPC minutes). According to the monetary policy literature, the increase in interest rates in order to choke off inflationary pressures would have been larger (and/or more frequent) if there had been no uncertainty.
Therefore, movements of inflation back towards the 2% target have been slower than otherwise; indeed, inflation has been above the target for more than a year now.
Many thanks.

Posted by: Costas Milas at July 5, 2007 01:36 PM

In terms of my hope for a significant minority against the hike, because I think the case for it was much less clear-cut than appeared.

Costas, not sure I've got your point. Surely there will always be a degree of uncertainty when inflation moves away from target? Or is it that the Bank has chosen to emphasise the greater uncertainty around its inflation projections?

Posted by: David Smith at July 5, 2007 02:02 PM

Dear David,
In theory, when actual and future inflation become more volatile, the MPC become more cautious (to avoid regretting a decision shortly after).
Actual inflation has recently moved all over the place (up from 2.4% in October 2006 to 3% in December 2006, then down to 2.7% in January 2007 and then up again to 3.1% in March 2007, only to drop down to 2.5% in May). Since volatile inflation feeds into a volatile forecast, the MPC could have chosen to respond more often (by raising or lowering), more radically (by 50 basis points), therefore hitting the target more often.
Many thanks.

Posted by: Costas Milas at July 5, 2007 02:51 PM

Perhaps they should hike until CPI drops to around 1% (cpi target @ 2% +/- 1% is it not?. And cpi is the only real measure that they are concerned with, so they keep telling us).

After all, some of us actually still SAVE money in a bank! (sorry about the caps, I have no idea how to implement italics in this blog - [i][/i] doesn't work).

Posted by: Matt at July 5, 2007 08:35 PM

David,
I think rates will probably end up where they belong, between 6% and 8%, with temporary "holidays" in the 4-5% range. It has worked like that for most of the past 50 years, I am not wishing we ever again have IR's of 15% but in order to do that MPC has to stay "vigilant" (like M Trichet loves to say). The question is how we are going to deal with the massive personal and public debt hangover, and in particular the unwarranted, irresponsible "top-up" accrued from 2005 to date.
Regards

Posted by: Michele at July 5, 2007 11:46 PM

Regarding the uncertainty of the inflation outlook, the MPC have emphasised this in several of their recent meeting minutes, saying that the outlook is less certain than usual. I'd imagine one of the outputs of their modelling is a confidence measure, and that that is lower than usual.

Posted by: Minh at July 6, 2007 07:47 AM

Dear David,
Recent history sometimes helps. The average real interest rate (since the BoE was given operational independence) stands at about 2.8%. This is true both before 2004 (when RPIX was targeting) and since then (and irrespective of using actual inflation or the 2-year forecast). With current inflation at 2.5%, this implies that a nominal interest rate of 5.3% is about right. In other words, yesterday's rise to 5.75% or figures above 6% could/should be a blip.
Many thanks.

Posted by: Costas Milas at July 6, 2007 11:07 AM

It's not sensible to think of average interest rates in that way because there are such significant breaks in the series. So the average since early 1993 has been 5% and the average from 1979 to 1992 was 12% - with a lowest rate of 7.5%. The average in the 1950s was 4% to 5%, that in the 1960s 5% to 6%.

Posted by: David Smith at July 6, 2007 11:08 AM

Costas,
Thanks - I was responding to the earlier comment from Michele.

Posted by: David Smith at July 6, 2007 11:09 AM

Dear David,
As you mentioned in your latest Sunday Times article, Divisia Money (which grows less than aggregate M4) has stronger links to aggregate spending. Boe staff have made a tremendous effort to produce a reliable measure:
http://www.bankofengland.co.uk/publications/quarterlybulletin/qb050103.pdf

Even this most representative measure of money has no significant impact on inflation. In that sense, it is at best puzzling why money features in the latest statement.
Many thanks.

Posted by: Costas Milas at July 6, 2007 12:00 PM

Inflation expectations will prove difficult to establish and given the fact that oil prices are irrelevently high does put the MPC on the spot.It is sensible to target broad money when it gets to a high level as it is now, cause IR increases help both measures, the other being inflation.

Broad money or M4 does play a bigger role than assumed and understandably has both the Governor and his deputy wanting to control it. Simply, IR increases will continue to bring inflation back to 2% with broad money targetted at the 9-10% range.Whether this will be met will be the next determinant for discussions come November.

The Government can count itself lucky if oil prices do come down, due to increased supply.

Posted by: H.Damani at July 6, 2007 01:09 PM

Hi Costas

With ot trying to do it all for you. (Basically because I'm knackered, and haven't my spreadsheet handy)

Try removing domestic energy from you CPI numbers, and see what is going on (IIRC wieghting dom energy 3.9%, and I'm sure you know the code OTTOYH, more than I do IIRC it has a D in it ;)

Cheers

Kon

Posted by: kingofnowhere at July 6, 2007 09:29 PM

To be honest, I would not necessarily want to remove energy as it is part of the picture. Interestingly though, the pre 2004 real interest rate has been more persistent ("non-stationary" in statistical terms) than the one afterwards. In other words, following an inflationary shock, the real interest rate is expected to revert back to 2.8% at a faster rate nowdays. Hence, unless something extraordinary happens, the base rate should revert back to around 5.3% rather soon.
Many thanks.

Posted by: Costas Milas at July 6, 2007 10:11 PM

Hi Costas

The reason I said remove the domestic energy, is because it is IMHO a "spike" that is passing though, the Headline CPI numbers. It peaked in March added 1% to the CPI headline number. In DEc theis year it will be taking 0.1% to 0.2% off the headline number.


Interesting comments, about inflaton and interest rates. I would be good if you joined the "Secret board" (Hidden below DS advert for the Dragon and the Elephant), on the left. You can post graphs etc there!

Take care

KoN

Posted by: kingofnowhere at July 7, 2007 10:02 AM

Is the 'China effect' really reversing?

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/07/07/cninfla107.xml

Posted by: Mr Naresh Radson at July 7, 2007 12:52 PM

I'd rather you didn't pollute the site with this kind of thing. Seriously, there is a good piece in the latest bulletin from the European Central Bank on this:
http://www.ecb.eu/pub/pdf/mobu/mb200706en.pdf

See pages 90-92. It suggests there is more to come, and I agree.

Posted by: David Smith at July 7, 2007 01:53 PM

Costas - amazing that someone quite intelligent should say that inflation is 2.5%. It is more like 5% (RPI). CPI - as you ought to know - is not real to real people, companies or the state. Real IRs are still at least 1 or 1.5% too low. Also, given increasing global cost of food, fuel and other commodities - I see 8% a distinct possibility by 2009...unless GB gets rid of MK and puts in Lomax or Barker. God help us.

Posted by: Jonathan Davis at July 8, 2007 10:40 PM

Jonathan - CPI has its flaws, and I know statistics aren't your strong point, but surely you must be aware of the very basic error in what you are saying. You can't use RPI, which by the way is at 4.3% not 5%, because that itself is affected by interest rate changes. So you could keep on raising interest rates and not reduce the real interest rate. You might use RPIX, which has inflation at 3.3%. The usefulness of CPI is that it provides a comparator. So on the basis of current (i.e. backward-looking) CPI, Europe has a real interest rate of 2%, Britain 3.25%.

Posted by: David Smith at July 9, 2007 08:56 AM

3 years ago the S Times was £1.20 - now its £2. Recently The Times was 50p - now its 65p. FT was £1 now £1.30.
Council Tax is up 5%. Oil is over $70. Food is rising rapidly.

I guess you're right - there's only 2.5 to 3.5% inflation if you don't live in a house, eat, heat yourself, drink water or travel.
Hmmm.

Posted by: Jonathan Davis at July 9, 2007 10:48 PM

Hi Johnathon

"I guess you're right - there's only 2.5 to 3.5% inflation if you don't live in a house, eat, heat yourself, drink water or travel"

Perhaps you could tell me where the RPI is missing these items?

Housing is certainly in there (Both rent and OO)
Food is as well
So is domestic energy
And so is water
And so is travel

Posted by: kingofnowhere at July 10, 2007 08:56 AM

I have done the numbers for the CPI without energy costs.
It is currently 2.26% compared to headline CPI which is 2.54%.
Assuming the CPI ex. energy does not change, then the headline CPI will drop back to around 2% by November.

However...

In Sept '06 the CPI ex. energy was only 1.48% and it was this that made the BOE more relaxed about interest rates in Q3 2006. However the rapid rise in underlying inflation in Q4 2006, Q1 2007 and Q2 2007 is making the BOE nervous and hence the recent increases in the base rate.

Currently there is high international inflation in fuel and food costs and it is likely that this will feed through into the underlying CPI in the next couple of months. It is difficult to see how increasing UK interest rates can do anything about rising international price pressures - other than by causing an rise in the pound and consequent slaughter of our exporting industries :-(

That won't stop the BOE doing it though!

Posted by: Matthew at July 11, 2007 11:41 AM

HI Matthew

I totally agree with your comments. The underlying inflation has picked up, and that is what is concerning the MPC (Which is why they keep saying that they are trying to look past the energy spike)

The next question I ask myself is

Is underlying inflation (Ex Dom En) being driven by the pass through from the energy price increases? It could be that they rose, because of the thier energy costs, with say a 4 to 6 month delay? If that is the case we may could get CPI (Ex domestic energy), falling later in the year.

If that is combined with, the Dom Energy numbers, we could get some very low CPI numbers.

Of course there are other inflation pressures out there, and not all the "underlying" CPI rise is due to pass through.

Food (Yep, great having set aside!)
Clothing not falling (EU restriction on Chinese goods)

The August inflation report will be interesting, I look forward to the fan chart of the CPI to see where the BOE think inflation will be 31/12/07

Also looking at the numbers, it is hard to "blame" the MPC for letting inflation tick over 3%. What could the realistically have done?

Posted by: kingofnowhere at July 11, 2007 11:58 AM

Digging around in the detailed CPI figures is interesting. The main factors with a big weighting that are forcing up the CPI at the moment (apart from energy) fall into two groups. The first is influenced by volatile costs and international factors such as food and alcohol.

The second is services like restaurants and hotels, domestic services, household repairs etc which are more influenced by the cost of labour. Furniture and furnishings are also rising at an above average rate (albeit only just).

The items with a big downward influence on CPI are clothes, electricals (both "brown" and "white") and communication (phone, broadband etc).

The BOE won't be too concerned with food and other volatile items as these are either influenced by short term factors like the weather or things they have no control over like international markets.

What will be worrying them is more "sticky" non-volatile inflation in the household services sector which are more influenced by labour costs. These have remained stubbornly high and it is this sort of cost that putting up interest rates is designed to suppress.

The ever falling cost of electricals is just astonishing and one wonders how long it could last. The rise in the pound may help to extend it a bit longer, but it is likely that this "China" effect will decline at some point.

One peculiar item that has pushed up inflation is the introduction of tuition fees that came into the CPI last October. This immediately added 0.25% to the CPI. Provided tuition fees do not rise too much there will be a drop of 0.25% in the CPI in October 2007 entirely due to this one item. Add that to the fall in energy prices we are currently seeing and the CPI is likely to hit, or drop below, the 2% target in October.

Posted by: Matthew at July 11, 2007 02:46 PM

If CPI falls below the target by October (and they should be able to know better than us), it will create what I will call an "inflation target illusion", that is, the false impression that inflation has been sorted out. The illusion will make it more difficult to digest another interest rate increase in the last quarter of 2007 (even if needed). Discounting this possible scenario might explain why they took action last week (even if the case was not that strong).
Many thanks.

Posted by: Costas Milas at July 11, 2007 07:54 PM

Hi Costas

I agree with you, that they may made the move, because the "window" was closing.

However, the MPC have moved before when the CPI was 1.1% (IIRC), back in Feb 2004.

Posted by: kingofnowhere at July 12, 2007 08:24 AM

Good point, Costas, you are probably right about it being politically difficult for the MPC to argue another rise in interest rates when the CPI is actually below target, hence the last three rises in fairly quick succession while the CPI is high. However, I see the window remaining open for another 2-3 months particularly if the CPI ex domestic energy stays above 2%.

The BOE repeatedly state in their inflation report that they aim to hit the target 2 years down the line, by which time any current short-term effects will no longer be a factor. However most journalists might find that a difficult one to grasp!

My personal prediction is that the June, July and August CPI figures will be poorer than they hoped with rising petrol prices and food costs. The fall in domestic energy prices also appears to have stalled. This will probably give the hawks on the committee enough amunition to swing another quarter point rise before the CPI hits the 2% target in October.

Personally I think that will be heading for over-kill. There is a credit crunch going on in the corporate bond market as well as a rapidly rising currency that is threatening to choke off a recovery in manufacturing. Layering higher rates on top of that at the same time could tip a lot of businesses over the edge.

Combined with a tight public spending round leading to further layoffs in the public sector, expect to see rising unemployment in Q1 2008.

Posted by: Matthew at July 12, 2007 11:06 AM

Inflationary pressures are building in China. Again, we're seeing strong agflation.

Just been speaking to a business contact in the USA and he's seen corn prices, for his hens, increase 60% since late last year. He blamed biofuel production.

http://www.ft.com/cms/s/22fcd90c-32ef-11dc-a9e8-0000779fd2ac.html

Posted by: Mr Naresh Radson at July 16, 2007 02:26 PM

Well the June inflation out this morning figures do not make good reading. The headline CPI figure was down as expected, but this was due almost entirely to falling domestic energy costs.

The following annual price rises look grim:
Food +4.8%
Alcohol +3.4%
Furniture and household goods +3.8%
Health +3.4%
Transport +3.2%
Restaurants and hotels +3.7%

With all that lot rising in price faster than the target of 2%, the target is going to be very difficult to hit.

In the last 6 months inflation in furniture has moderated and the 6 months annualised figure is now 1.4%. However, the 6 months annualised figure for all the other items listed above is still higher than the 2% target, implying that underlying inflation in these items will continue to be higher than the 2% target in the next few months.

Food is currently growing at a 6 month annualised rate of 3.6%, Alcohol at 8.1%, health at 3.7%, transport 7.9% and restaurants at 4.3%.

The sensible policy would be wait and see what the effects of the rate rises to date has been before increasing rates again. However I have a horrible feeling the hawks will get their way again and we will see another rise in rates to 6% in July or August.

In October and November inflation will take a sudden dip below 2% as the university tuition fees that were introduced last year fall out of the figures.

It will then be very difficult for the BOE to foist further rate rises on us after that point and CPI should then stay below target until May '08, even with underlying inflation at its current elevated levels. By then, if the economy and house prices slow down as expected, then lower inflation should follow and further rate rises won't be needed, although I reckon we are stuck with around 6% rates for another couple of years :-(

Posted by: Matthew at July 17, 2007 11:34 AM

David, the 64 dollar question of course, how far do you think they will rise?

I know you've said they would remain at 5.5% before now but its clear that the City of London are pricing in 6.3% 2 years hence - and of you read the doom mongers in Fantasy Island ...

What's your take?

Posted by: Pete Balchin at July 19, 2007 09:56 AM
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