29/10/2007
Scotland on Sunday 29 October 2007
Rate cut – but not yet!
This summer’s problems in the financial markets and the less optimistic outlook for global growth have raised expectations for lower interest rates. However, the Bank of England’s Monetary Policy Committee (MPC) voted 8:1 to keep interest rates on hold at their last meeting. Will they cut at a future meeting, or will they remain on hold?
The market is currently convinced that the Bank will eventually cut, in February next year. At the moment, the case for an urgent move is not seen as sufficiently persuasive. Next spring though, there will be much stronger evidence on the state of the economy, a clearer grasp of the fall-out from the turmoil in the financial markets, and more signs of the impact of the squeeze on consumer spending. All these will be key to the Bank’s next move.
The dilemma for the Bank today is that there is no compelling evidence to adjust the level of rates, either up or down. The economy has been growing above trend for the past six quarters, and the Bank is well aware that this presents a potential threat to inflation. This ongoing threat meant a rate rise was kept on the “front burner”, until the summer’s financial troubles emerged. Until now, this high level of activity has not resulted in higher inflation. The Bank has been monitoring, through their regional agents, several variables to determine just how significant the inflation threat is. They are interested in how easy or difficult it is to recruit labour, whether companies can easily raise prices, and expectations about future inflation. The evidence, so far, would not support the case for an interest rate cut.
Given the intensity of the squeeze facing the consumer, it had been widely expected that household spending would have fallen back by now. However, retail sales have defiantly surprised to the upside. This is despite the impact on personal spending power from a succession of tax increases, higher interest rates and the surge in energy and food prices. On top of all that, the credit crunch has led to tighter lending restrictions. Surely this defiance will finally be broken as the financial screws continue to tighten.
One important point bolstering households’ wellbeing has been the continued resilience of house prices. There has been a sharp fall in prospective demand for housing, which normally feeds through into a lower level of mortgage approvals and from there weaker house prices and retail sales. The difference in this cycle is that approvals have not collapsed and hence house prices have continued to rise. This rise in house prices has allowed households to take out re-mortgages, and use this excess to sustain their spending power. When house prices cease to rise, this contribution to potential spending power will be closed off. We are not there yet, but the Council of Mortgage Lenders did report a fall in home loans of 12% from August to September, more than double the normal decline at this time of year.
Another threat to growth comes from its present source of strength. Business services and the financial sector currently account for over one quarter of the UK economy. The preliminary estimate is that economic growth was 3.3% over the last three months compared to the same period last year. The strongest area was business and finance, surging by 5.6% a year, meaning that the rest of the economy was only growing at a 2.4% clip. Now, it must be expected that the financial upheavals of the last few months will have an impact on the future growth of this sector, and consequently the general economic outlook. The evidence to date is that certain activities have indeed been disrupted, job losses have been announced and lending criteria have been tightened.
The dilemma then for the Bank is that it can see the vulnerability of the present environment, but it can also see the signs of strength. It is also painfully aware that the last interest rate cut quickly re-ignited the housing market. With present house prices around six times income levels, the Bank will want to avoid a repetition. This would favour a wait-and-see period during which house prices could hopefully adjust in an orderly fashion.
Reading the minutes of the Bank’s October meeting, there were some points of concern. A pre-emptive cut in interest rates was considered, in order to “forestall a sharper slowdown in output growth than had been judged necessary to meet the inflation target”. However, the Bank also decided that “it was important not to prevent the slowdown ……” by loosening policy too quickly. These quotes help to highlight the delicate balance of judgement that is going to be required to “cure the patient without killing him”.
Douglas Roberts, Senior International Economist at Standard Life Investments.
Standard Life Investments Limited, tel. +44 131 225 2345, a company registered in Scotland (SC 123321) Registered Office 1 George Street Edinburgh EH2 2LL.
The Standard Life Investments group includes Standard Life Investments (Mutual Funds) Limited, SLTM Limited, Standard Life Investments (Corporate Funds) Limited and SL Capital Partners LLP. Standard Life Investments Limited acts as Investment Manager for Standard Life Assurance Limited and Standard Life Pension Funds Limited.
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