Could we be in for an interest rate cut this week?
There are two very good reasons why the Bank of England will be feeling far less hawkish now than it did this time last month. But those City pundits predicting cuts should be wary of getting carried away.
There is a story, somewhat apocryphal I suspect, about a blue-bloodied City institution in the 1980s. Mrs Thatcher had accepted an invitation to lunch there. The Prime Minister was in her pomp and in extremely high regard at the time. The host directors spent all morning fussing over the seating plan, the menu and the wine list. When Margaret Thatcher entered the dining room and fixed the directors with an icy glare, she asked "what do you think of this morning's PSBR figures?" There was a collective gulp, before one of the directors rescued the situation by saying, "You can't read too much into one month's figures". To everyone's relief the Prime Minister moved on but had her hosts on their toes for the rest of the lunch!
This catch phrase is very apt today as the markets exhibit huge mood swings. On August 9th the front page headline of the Financial Times declared "Rates set to hit 6% by the end of the year". This followed the publication of the Bank of England's quarterly inflation report, where it warned that UK inflation risks were "slightly on the upside". Its forecast suggested that without an increase in rates to 6% inflation was likely to continue overshooting its 2% target. But it was a forecast, nothing more, nothing less. Yet market commentators then concluded that the Monetary Policy Committee (MPC) had not put the medicine bottle away just yet, while one pundit reckoned that "A further rate rise was virtually a done deal".
There was also a concern about food prices. Prices of all kinds of food from staples like bread, fish and meat to more indulgent goods like coffee and chocolate had been pushed up surging global demand for agricultural raw materials, either to satisfy the demand for bio-fuels or respond to the changing diets of the more affluent Chinese. Moreover the flooding in the UK last month damaged vegetable and grain crops like peas, broccoli and wheat.
July inflation figures shock
So the release of the July UK inflation figures on August 14th were certainly a shock. The annual inflation rate plummeted to 1.9% from 2.4% in June, surprising a median forecast that was looking for a 2.3% figure for July. The drop in inflation was caused by a sharp monthly decline in food prices, alongside the largest monthly fall in furniture prices to date. Petrol prices also fell.
Falling food prices were driven by a new supermarket price war, which led to such phenomena as Asda's £2 chicken and £5 copies of the latest Harry Potter. Meanwhile the drop in furniture prices reflected a "DFS effect" whereby furniture stores push up their prices sharply in June, ahead of the summer sales, only to cut them even more sharply in July.
The surprise numbers confirm the wisdom that it is always best to be modest about the accuracy of economic forecasts. It also transformed the UK interest rate outlook. Rather than a hike in interest rates to 6% being a done deal, pundits now believe that a rate rise in September is highly unlikely, and economists no longer expect a hike until November, if at all. The headline in the Financial Times was now "Latest data cast doubt on need for rate rise".
Moreover the MPC minutes released on the following day contributed to the dovish tone. The committee voted 9-0 for no change in rates at its meeting this month, while most members emphasised they had no firm view on whether rates would need to rise further.
Credit market volatility
And what about the substantial volatility in financial and credit markets? There is a precedent. In August 1998, the Bank warned in its inflation report that the inflation risks were on the upside. Two months later the Bank of England cut rates by a quarter of a point in response to the Long Term Capital Management collapse.
So with inflation below target, stock markets in turmoil and a financial crisis brewing, are interest rate cuts back on the agenda? The simple answer is, "Don't get carried away".
For a start the scale of the "sub-prime" problem is much lower this side of the Atlantic. The market is much smaller, accounting for around 8% of mortgages in the UK compared with 20% in the US. In the first quarter of 2007 10.5% of sub-prime loans were more than 90 days in arrears, which is 0.84% of the UK mortgage market.
Moreover in the wider context of credit market dislocation lower interest rates are not the best solution anyway. Lower interest rates will temper investor losses if the problem is caused by a temporary lack of liquidity, but it will be less effective if the problem is caused by a de-rating of asset quality as is occurring today. Cutting interest rates for everyone does not encourage investors to take more care in the future. Emergency rate cuts just spawn further asset bubbles. The Bank of England recognises this and would be extremely unwilling to enact a repeat of 1998.
Furthermore the benign inflation numbers seen in July caused by lower food, furniture and petrol prices could easily go into reverse in the coming months, particularly as the impact of the floods has yet to come through in the official inflation measures. Indeed the Bank of England's often repeated strategy on interest rates is to aim to control the level of demand in line with what the economy can supply rather than responding to the most recent inflation figures. The Old Lady will certainly not be reading too much into one month's figures.
By Brian Durrant of The Fleet Street Letter, Britain's longest-running publication for private investors.