Jeremy Batstone of Charles Stanley wonders where interest rates in the UK and US are headed next. We don't always agree with his opinions, but his comments are always worth a read...
Falling energy prices have muddied the inflation waters of late. Both in the
United States and the UK monetary policy makers have to grapple with the fact that headline inflationary pressure appears to be wilting, while underlying inflation remains stubbornly above comfort levels. In such circumstances, with nominal short rates standing at 5.25% in the US and 4.75% in the UK, what will they do?
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We commented in last week's Week In Preview on the reasons why headline and core inflation have diverged and indicated that the differing remits enjoyed by the Federal Reserve and the Bank of England might call for a differing response. The manifestation of this differing response should be clear in the weeks ahead.
Annualised inflation slipped back from 2.5% to 2.4% here in the UK while a massive 13.5% decline in energy prices coupled with favourable base effects resulted in the US headline measure plummeting from 3.8% to just 2.1%! The monthly stats show headline UK inflation rising by just 0.1% in September but falling by 0.5% in the US (well below the consensus expectation for a 0.3% decline). The difference in the behaviour of monthly CPI can be explained by the fact that while oil prices tumbled in the UK too, the extent of their impact on headline CPI was muted by a rise in seasonal food prices and further increases in gas and electricity prices as earlier price hikes were confirmed. October's data is likely to be adversely affected by high profile increases in university tuition fees too.
The Burning Core
In both countries core inflation remains stubbornly above levels regarded as safe. Here in the UK the annualised core rate of inflation increased sharply, from 1.1% to 1.4%, its highest level since February. A bout of cooler weather at "back to school" time enabled retailers to push through price increases. This is not to say that the pressure on the High St. shows any sign of easing over the longer term, but endemic deflation did at least ease from -3.9% to -3.5% over September. In terms of furnishing and household goods, inflationary pressure did reassert itself, the month revealing a turnaround from -0.5% to +0.3%.
Over in the US a monthly increase of 0.2% resulted in annualised core inflation hitting a ten year high at 2.9%. Despite falling residential property prices another sharp increase in owners' equivalent rents (+0.3% over the month) accounted for much of the bad news. Furthermore, the weakness in house prices and concomitant recovery in rental prices is not expected to be a flash in the pan. OER is expected to continue rising well into 2007. If the Federal Reserve were to operate under the same remit as the Bank of England or the European Central Bank observers would probably regard
such a development as sufficient to ensure that US rates remained at prevailing levels for quite some time.
As we commented last week, however, the Fed attempts to balance monetary zeal with a desire to ensure sustainable economic growth and as such it may feel that sufficient scope exists to begin the process of monetary easing before underlying inflation data starts slipping back. If it didn't we would have to start building the likelihood of a "hard landing" into our economic forecasts (currently 40% probability) as a central projection.
Here in the UK the Bank is sending out strong signals to suggest that another 0.25% points on base rates might be due in November (to coincide with the latest Quarterly Inflation Report. The Minutes accompanying October's MPC meeting reveal a strong preference in favour of imminent policy action. While this would turn our early 2006 expectation that UK rates might be falling by end-2006 on its head it seems that the Bank's own representatives have been joined by new boys Tim Besley and Andrew
Sentence. Both voted in favour of a rate hike at the October meeting citing the recent strength in retail sales, continuing strength in the UK housing market, continuing strong money supply data and the general health of the global economy (albeit, as we have noted before, that the IMF and OECD's growth forecasts rather reflect a switch in global economic leadership from an inflationary West to a deflationary East). While the
other seven Committee members stuck to their guns there appeared no serious objection to the new boy's views, merely one of timing.
Whilst hard pressed consumers hardly need another rate hike in the run-up to Christmas (and neither do retailers!) some solace might be gleaned from the minutes themselves which seemed to indicate that the new boys might be taking the "stitch in time" view that a hike now may limit the need for further action over the medium term. The other, far from magnificent, seven speculated that pushing rates up now might impart a degree of tightening which might not be justified by prevailing conditionsbut they didn't seem to be arguing the point too hard.
Second-Round Effects
Underlying central bankers' concerns is the possibility that stubborn consumer prices may begin feeding their way through the supply chain down to wage demands. Wage push inflation is notoriously hard to eradicate and central bankers have a strong preference for limiting the criteria by which wage claims are set. Higher wage inflation limits the central bankers' scope to use monetary policy nimbly raising the possibility
that, with fiscal policy already constrained by a parlous fiscal position, other more serious economic crises might manifest themselves at some point in time.
In this context recent labour market data emerging in the UK is instructive. Data lags by a month but growth in three month average earnings fell from 4.4% in July to 4.2%. Excluding bonuses average earnings fell from 3.7% to 3.6%. It is possible that September's data could reveal a reversal of August's fall, however, we have always suspected there to be more slack in the UK labour market (and consequently greater spare capacity in the economy) than the official data cares to relate. Note that August claimant count data revealed a 10,200 increase in unemployment (and that's official
data!) where consensus had anticipated no change. Furthermore, August's gain completely wiped out the declines of the two previous months. The alternative measure of unemployment, the ILO measure, revealed a 45,000 increase in unemployment over August driven largely by a larger increase in the workforce (165,000) than employment (120,000).
On balance we suspect that consensus will be right and that over the next four weeks we shall see US monetary authorities holding steady (no need to rock the boat ahead of Congressional mid-term elections) and UK authorities pushing base rates up by a further 0.25% to 5.0% in November. Given clear evidence that the US economy is slowing and that more spare capacity exists in the UK economy than the governor of the Bank would care to admit, 5.0% looks like being the peak level for UK rates and
that a combination of slowing domestic economic activity, ebbing inflationary pressure, rising unemployment and a subdued January pay round could contrive to encourage the financial markets to begin anticipating lower UK base rates in the new year.
By Jeremy Batstone, Director of Private Client Research, Charles Stanley
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