IT HAS BEEN a sticky few weeks at the Bank of England. That has not been just because of the summer heatwave, or the hefty programme of research and discussion that comes every three months as the Bank puts together its quarterly Inflation Report. What really turned up the temperature this time was Thursday’s decision by the Bank’s monetary policy committee (MPC) to change interest rates for the first time in a year, pushing them up by a quarter point to 4.75%.
The MPC does not like to surprise the markets. In its ideal world, its approach to rate setting would be so well understood that its moves would be fully reflected in asset prices before they were even announced. That is why Mervyn King, the Bank’s governor, has often said he wants monetary policy to be boringly predictable.
Last week, 39 out of 46 City economists had forecast that rates would not change — so it was quite a moment when the MPC decided to prove them wrong. And we are left with two big questions. Why did the committee feel it necessary to move at this time, without taking another month or two to prepare the markets for a rise? And does the change represent only a precautionary touch on the brakes, or might there be more to come?
The arguments for an increase were set out in a robustly worded statement from the MPC that accompanied the news. Over the past few quarters, it said, economic growth in Britain had been running at, or a little above, its long-run average, and business surveys pointed to continued firm growth. Inflation as measured by the Consumer Price Index had picked up to 2.5% in June, and was expected to remain above the 2.0% target for some time. Taken together, this added up to a clear-cut case in the MPC’s view for tighter money, and the wording did not suggest there had been any hesitation on this front.
But there is more to it than that. For one thing, the growth and inflation figures during the second quarter of this year were right in line with what the MPC had been expecting in its May Inflation Report: so no reason here to expect a sudden reappraisal of the outlook. True, energy prices have continued to move up, but movements in asset prices since May will have pulled in the opposite direction. Equities have edged lower, while market interest rates and sterling have both moved higher: all this will tend to reduce expectations for domestic demand, and therefore for price inflation.
Most important, there are as yet few signs that the rise in energy prices, which lies behind the current increase in inflation, is likely to have a lasting impact on the economy. The MPC keeps a keen eye out for what it calls “second-round effects” — evidence that the initial energy-price shock is flowing through into the price of labour, goods and services, and thus threatening a sustained rise in inflation. But right now, such effects are hard to identify.
Growth in wages and earnings remains subdued, and a touch lower than the Bank had been expecting in May. And companies tell me they are still finding it very hard to pass higher energy costs on to their customers. Manufacturing margins are being squeezed; fierce competition is continuing to hold down prices on the high street; and price inflation has moderated across the services sector as a whole in recent months. The Bank’s agents said in their July report that, apart from energy-price effects, there was little evidence that underlying inflation was rising for either goods or services and there is no reason to think that things have changed since then.
Nobody knows what is going to happen to the price of oil. But there are certainly those in the industry who think that the current high price for natural gas has been inflated by anxieties about supply shortages this winter, which would be eased if new pipelines are installed on schedule.
Even before the rate increase, it seemed possible that business conditions might start to look less buoyant later this year and beyond. America no longer seems to be quite such an engine for global expansion: its initial estimate for growth in the first quarter was 2.5% — well below the Bank’s expectation. A slowdown here would quickly wash through into other important UK export markets, notably in the euro area.
British consumers could also be approaching a turning point. Unemployment is edging higher, earnings growth is restrained, and disposable incomes are being squeezed by higher energy and utility bills. That is hardly a recipe for high times on the high street.
At the last meeting, a month ago, the MPC concluded that “there were significant risks (to the outlook) in both directions”, and as a result the members voted unanimously for no change. They have obviously changed their minds since then, and next Wednesday we will get the first clue for the reason when King issues the Bank’s August Inflation Report at his quarterly press conference. One explanation might be that during their discussions ahead of the report, MPC members came to noticeably different conclusions about the outlook for growth and inflation over the next couple of years.
Maybe they revised down their estimates of the degree of slack left in the economy — always a slippery concept to get your mind round. Or perhaps they have become a bit more worried about import prices which, excluding oil and erratic items, now appear to have come to the end of a protracted period of decline that has lasted most of the past decade.
Alternatively, they might simply have decided that a modest rate rise had become inevitable in the coming months, and that they might as well get it out of the way — even at the price of surprising the markets.
But we will have to wait until next week to get the answer to the vital question: just how close a call was it last Thursday? The minutes of last week’s MPC meeting, to be published on August 16, will tell us about the tone of the deliberations and how the voting went, which in turn will help to form judgments about what might happen next.
An insider’s joke on the committee is that each member should be allowed nine votes, rather than just the one. That way, you could get a much clearer picture of how close individual members were to changing their views. For example, a vote last month of 35-28 would have told a very different story compared with the actual outcome of 7-0 for no change. But that is not going to happen, so the financial markets will be scanning every syllable of the minutes to form a view of where the MPC might be heading next.
Consumers, especially those saddled with a lot of debt, will be hoping for signs that this was no more than a precautionary increase, and does not signal further rate rises. So will businesses, which will now have to add higher borrowing costs and a rise in sterling to their existing problems. It will not be only the Bank that will be feeling a little sweaty in the next couple of weeks.
Richard Lambert was an external member of the MPC from June 2003 until last March, the first non- economist ever to hold such a position. The MPC is responsible for setting interest rates to meet the government’s inflation target
