The Bank of England's Quarterly Inflation Report provided a severe jolt to those who previously believed that UK base rates might have peaked at 5.5%. As ever, the Report showed the targeted measure of CPI inflation hitting its 2% target over the two year forecast horizon, however, the Report forecast average base rates of 5.7% between Q3 2007 and Q2 2008 before dropping back to 5.5% by 2009. Furthermore, the Report indicates that even using this raised profile the risks to inflation remain skewed to the upside judging by the range of possible outcomes spread between 1% on the downside and 3.5% on the upside. The clear conclusion, and that immediately factored in by the financial markets, is that UK base rates might not even have peaked at 5.75%.
UK interest rates: why they could go above 5.75%
In April the Bank's Monetary Policy Committee (MPC) was forced to write an open letter to the Chancellor explaining why the targeted measure of inflation had risen above the top end of the 1% - 3% range following the release of that month's data (to 3.1% year on year). Interestingly, the reason for April's inflation surge, strength in fuel, food and furniture prices, was not cited as the underlying justification for the more bearish profile indicated in the Bank's Quarterly Report. Instead the emphasis on higher underlying inflation was placed at the factory gate with increased company pricing power identified as the key threat. With the public sector pay round in the past and energy effects fading the Bank had to come up with an alternative scapegoat to justify its position.
Concerns regarding rising pipeline pressures were evident in Monday 14th May producer price data and the seriousness with which the bank regards that piece of data was evident in the fact that the Quarterly no longer sees inflation falling below 2% beyond the two year forecast horizon. It might be possible to conclude from this that the Bank does not see any pressing need to reduce base rates much once the peak has been reached. Doves might cling to the Report's nod in the direction of slower US GDP growth and the potentially adverse impact of high debt levels (the UK consumer's savings ratio is now in negative territory, just as it is in the US), but the Bank maintains its tough line, confirming in a remarkably upbeat assessment of UK economic activity, Mervyn King's long-held belief that the domestic output gap is extremely narrow and the muted impact of a stronger pound against the dollar.
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UK interest rates: the retail threat
April consumer price data (released in May) showed the annualised measure of CPI inflation dropping back to 2.8%, but that down almost entirely to sharp falls in residential gas and electricity bills, coupled with fading energy price effects. The underlying, or core, rate of inflation only eased slightly from 1.9% in march to 1.8% in April, reversing only half of March's increase. The MPC is likely to be concerned by the fact that while furniture and household goods inflation did fall, it only fell back from 2.7% to 2.2% while clothing and footwear deflation reduced markedly from -3.9% to - 2.8%. While warm April weather may well have contributed to the latter, until future data confirms that April might have been a blip the fear is that producer pricing pressures are beginning to manifest themselves at the end of the "pipeline" in the form of higher prices to shoppers.
By Stephen Roach, global economist at Morgan Stanley, as first published on Morgan Stanley's Global Economic Forum
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