It is self-evident from the voting figures a 5:4 majority for a rate cut with the Governor voting against the 25bp reduction to 4.5% that the decision made by the Monetary Policy Committee at the Bank of England on August 4 was, as we had always expected, very finely balanced. It is also likely that future decisions will be finely balanced.
Given the economic backdrop it is not surprising that the decision to reduce rates was anything but clear-cut. As the minutes observe:
"CPI inflation was on target at 2.0% in June, a little higher than expected. Although there was continuing uncertainty about the reasons for the recent increases in CPI inflation, the oil price was likely to have played a sizeable role through both direct and indirect channels, and looked set to do so for some time given the continued rise in oil prices. The pressure of demand on supply in early 2004 was also likely to have played a significant role in the rise in inflation towards the target."
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Yet growth had clearly slowed in the first half of this year though even here there was uncertainty about the scale of that slowdown and an expectation that provisional figures for output might be revised up:
"The evidence from the labour market was also broadly consistent with growth somewhat below trend. Nevertheless, on balance it still seemed likely that recent ONS output data would eventually be revised up a little. The June Index of Production release had been provided to the Committee ahead of publication. The June outturn, together with revisions to earlier months, suggested stronger-than-expected manufacturing output in Q2. On the basis of these numbers, it was possible that the ONS might subsequently revise up the preliminary GDP growth estimate in the next release."
Whether consumer spending would grow at closer to trend in the second half of the year was also hard to judge:
"Overall, the indicators did not yet provide a clear steer as to whether the stronger consumption growth now expected for Q2 would be maintained into the second half of the year, or whether the weakness over the first half of the year taking Q1 and Q2 together would continue."
All in all with output close to full capacity, inflation already at the 2% target and expected to rise a bit more yet and with a reasonable chance that growth would naturally pick up in the second half it is not surprising that some members felt the case for a rate cut in August was not compelling. It is also clear that those who did, on balance, feel that a 25bp cut was warranted did not presume that further rate cuts were likely to be desirable:
"For these members, there was no presumption on the future direction of interest rates".
Where next?
It is clear that rates at 4.5% a level consistent with the MPC's central expectation being that inflation is close to 2% two years ahead might persist for some months. There should be no expectation that further rate cuts are highly likely. With the evidence so finely balanced, and given the 5:4 vote, it is not implausible that the rate cut in August is reversed, though that might be more likely a few months down the line than in the next month or so. One reason that a reversal in the near term is somewhat less likely (even if some of those who voted for a cut may decide that starting with a blank slate they would even now judge 4.75% to be the right rate) is given in the outline of the case made by some of those who voted against a rate cut in August:
"Given the difficulty in explaining a reversal of a decision soon after a turning point, should that prove necessary in the light of future data, it was advisable to accumulate a little more evidence than usual before changing interest rates. While a decision not to cut rates would be a significant surprise, the Committee's latest projections did not support the current market view that a sequence of interest rate cuts was likely to be needed to meet the inflation target in the medium term".
Paradoxically though perhaps intentionally in spelling this out so clearly they make the chances of a rate reversal somewhat higher since it has now been flagged that such a move might well prove sensible in the light of new information over the next few months.
Our central guess remains that rates may stay at around 4.5% for the rest of this year but that the next move in rates is rather more likely to be up than down. As a central forecast we assume a rate rise of 25bp (from 4.50% to 4.75%) in the first half of 2006.
By David Miles, Morgan Stanley economist as published on the Global Economic Forum
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