Once upon a time, not too long ago, Bank governor Mervyn King
commented that it was his intention to make monetary policy setting "boring". But Bank governors clearly have a flamboyant streak lurking behind endless grey suits and so early August's surprise 0.25% point increase in the UK's base rate, to 4.75% (and reversing August 2005's isolate rate reduction) caught most financial market operators on the hop.
Interest rate rises: what the MPC minutes tell us
The Minutes outlining the debate at that policy committee meeting indicate a 6 : 1 majority in favour of a nudge on the base rate tiller, a pretty wide margin even accounting for the fact that the nine person Committee was short by two independent members. This fact spawned a number of conspiracy theories, chief amongst them being that Mr King took advantage of the possible absence of strong contrarian debate to drive the Bank's anti-inflation agenda aggressively. Whilst the Minutes do indicate that the decision was at least taken at the conclusion of constructive debate (and one independent member, David Blanchflower, going against consensus in only his third meeting) one cannot quite escape the feeling that the sub-plot might have been to provide Mr King with sufficient ammunition, were targeted inflation to rise temporarily above the top end of the 1% - 3% band within the two-year time horizon, to fill an open letter of explanation to the Chancellor.
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Interest rate rises: inflation expectations
As Committee members sat down to consider the economic tea leaves the UK's targeted Consumer Price Index (CPI) stood at 2.5%, above the 2.0% envisaged over a two year time horizon. The Bank's Quarterly Inflation Report, released the week after the MPC's decision revealed its perception that targeted inflation might track higher in the very near term, before slipping back towards the target at the end of the period. The knee-jerk reaction to this and the Bank's decision was to assume that there might be more rate hikes on the way.
Having caught the financial markets by surprise (did anybody say boring?) thus forcing a rapid re-think regarding future inflation expectations, the Bank sat pensively waiting for the release of July's factory gate and consumer price inflation data. We have long argued that inflation, although the central banker's nightmare, is little more than the dog barking in the night! Despite the most aggressive spike in energy and raw material prices in three decades, what differentiates this economic cycle from those of the past is the limited extent to which these spiking prices are finding their
way down the production chain to worker's pay claims (a point at which monetary policy setters really should be concerned). In the event it was the Bank, not us, who were surprised the most by the data.
Interest rate rises: UK factory gate prices
Input price increases have begun to top out after earlier strength, reflecting higher energy and raw material prices, but output prices remain subdued, reflecting the fact that many companies are struggling to pass higher input costs on to customers in full. The fact that profit margins are at cyclical highs indicates that the discrepancy is being made up for by ongoing cost cutting. Core output prices (excluding energy and fresh food) rose by just 0.1% in July, its weakest monthly increase since October 2005. Growing evidence of slowing demand overseas (particularly in the United States) may further constrain output prices in the months ahead. Note, too, the fact that core goods prices are still falling at an annualised rate of 2.0%, indicating that general retailers are still struggling to pass any higher input costs on to consumers on the High St. This is a significant development and one which in our view, should limit wage push inflationary pressure from developing. Coupled with rising unemployment (on the wider ILO calculation) we remain relaxed regarding levels of spare capacity in the UK economy.
The remarkable feature of the CPI figures is the sharp drop in the core rate (excluding food, energy, tobacco and alcohol) over July from 1.2% in June to just 0.9% in July. In part this was down to retailers, referred to above, resorting to aggressive price discounting to get customers into stores. The MPC plays down core inflation, however, it is significant in that rising energy prices are not putting upward pressure on inflation through higher
production costs!
Whilst nobody should be complacent about the possibility of inflationary pressure reigniting recent data does go a long way towards confirming the absence of any major inflation threat in the UK at this time.
Interest rate rises: the bigger picture
The Bank's move has helped to strengthen sterling's position on the foreign exchange market, thus limiting the near-term risk of imported inflationary pressure. With this in mind we examine July's data released in both the US and the Eurozone.
The dollar's nascent recovery has been nipped in the bud by continuing weak inflation data in the United States. The Federal Reserve's decision to hold off from an eighteenth consecutive increase in the Fed Funds rate looks right in the light of further benign data at the factory gate. US producer prices edged down at both the headline and core levels over July. Most dramatic was the 0.3% decline in the monthly core data reflecting weakness in prescriptions and car and truck prices (financial markets
had been expecting a 0.2% increase). This very benign data should, at the very least, encourage the Fed to look beyond inflation data towards life in the real economy. Here recent data points to a pronounced softening.
US consumer prices are equally becalmed. The headline rate of US inflation fell from an annualised 4.3% in June to 4.1% in July while the month on month increase in core inflation was just 0.2% from 0.3% in June. The slowdown in the US housing market is manifesting itself at the core level where owners' equivalent rent increased by 0.4% again (increased demand for rented accommodation amongst other factors) but where clothing and Medicare prices proved an effective counter-weight. The annualised rate
of core inflation did, however, tick up from 2.6% in June to 2.7% in July, some distance from the Fed's comfort zone. This justifies the Fed's statement accompanying its 8th August rate decision within which it maintained its bias towards further policy tightening should it be necessary.
A slightly different picture emerges in the eurozone where activity levels are hitting their highest levels in half a decade.
July inflation data revealed annualised CPI inflation running at 2.4%, marginally down on the 2.5% recorded in June. The underlying rate of inflation (excluding energy, food, alcohol and tobacco) held steady at 1.4%. The European Central Bank (ECB) eyes prices excluding energy and unprocessed food (a sub-set of the core inflation data) and here the annualised rate increased slightly from 1.5% in June to 1.6% in July. The combination of subdued inflation, coupled with robust activity may well be
sufficient to encourage the ECB to raise the regional base rate again in the autumn, however, its stated intention, to remain "behind the curve" in order to give the region's economies the best possible chance of sustained recovery over the longer term looks right to us.
Interest rate rises: the next chapter
While global central bankers have worked hard to build credibility with the financial markets by telegraphing policy in advance, the Bank of England's MPC has been called into question following it's early August move, particularly as more recent data has been skewed towards softer activity levels (c.r Retail Sales). Unlike some observers we do not see the need for further policy tightening and suspect that, were activity data to soften further the Bank might be forced into an abrupt about-turn.
Furthermore, the impact of 2005's energy price increases should gradually drop out of the annualised calculation of inflation as this year progresses, indicating that downward, not upward, pressure on targeted inflation should begin to reassert itself as time passes.
By Jeremy Batstone, Director of Private Client Research at Charles Stanley
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