The latest interest rate cut will be short-lived
With rapid economic growth and accelerating inflation, the Bank of England's latest interest-rate cut may soon look like a mistake, says Matthew Lynn.
If any of us had a tenner for every time since the financial crash a City economist had predicted the Bank of England would raise rates, we would have enough money to buy a medium-sized Caribbean island by now. There have been so many forecasts that rates would start getting back to normal that most of us have stopped even listening to them.
As it turned out, the result of the EU referendum meant that we got a cut before a rise. The Bank spent so long warning everyone that Brexit would be a disaster for the economy that it boxed itself into a corner where some kind of stimulus was inevitable once it happened. Cutting rates to 0.25%, and promising more down the line if necessary, may have seemed like the least it could do.
Yet there is no reason to think that the referendum will make a huge difference to the economy. Yes, the manufacturing sector could be hurt if we leave the single market but that only accounts for 12% of the economy, and the EU only accounts for 44% of our exports.
So even in the worst-case scenario, in which we completely lose open access to the EU market, and face the modest tariffs allowed under World Trade Organisation rules, only about 5% of the economy will be affected. And we haven't even left yet, or begun the process of departing. So nothing has actually changed, nor will it for some time.
True, confidence has taken a hit, and the Bank's surveys have taken a downturn. But what else would you expect? Every expert on the planet has been screaming about how Brexit would be a catastrophe. If that doesn't make people feel a bit less chipper, it is hard to know what will. While confidence certainly affects the economy, it is hard to work out exactly how, especially on something like Brexit.
Against that, the UK has just had a massive stimulus. Sterling has been devalued by around 10%, which should boost exports. At the same time, the government has abandoned fiscal restraint, such as it was. It is no longer planning to balance the budget in this Parliament, and is likely to spend more on infrastructure and cut some taxes. Again, that is going to boost demand.
That stimulus, remember, will be for an economy that was already running at close to full capacity. Employment was already at record levels, and unemployment was less than 5%. House prices were surging. Asset prices were high, and consumer spending buoyant. Meanwhile, sterling's devaluation will inevitably feed into higher prices. And the living wage, plus potentially less immigration now that we are heading out of the EU, may well lead to a faster acceleration in real earnings.
Put that all together and what kind of picture emerges? By the end of the year, the UK will be growing faster, probably more rapidly than any other economy in Europe, and faster than the Bank has forecast. Wages and prices will start to accelerate, possibly quite sharply it is unlikely that we will actually be back to the 2% official inflation-rate target by the end of this year, but we might well be getting close to it.
The net result? With rapid growth and accelerating inflation, that cut in interest rates will look like a mistake and the Bank will have an excuse to declare the emergency over and tweak rates back up to 0.5%. This may well turn out to be the shortest rates cycle we have ever seen.