CHANGES in interest rates in Britain used to be as common as blackbirds but are now almost as rare as golden eagles. So it was just my luck to be away last week when the hawks flew into view.
Fortunately, we get several bites at the cherry these days. First was the announcement itself. Then last week we had the Bank of England’s quarterly inflation report, much of which was devoted to explaining it.
Finally, we will this week get the minutes of the MPC (monetary policy committee) meeting that decided on the rise, including the all- important voting figures. I suspect, for all the talk of a knife-edge verdict, the decision to raise from 4.5% to 4.75% on August 3 was clear-cut.
Before I get into the meat of that, I have been doing a bit of detective work on why so many people were wrongfooted by the rate rise, leading to a bad reaction in the markets. Mervyn King, the governor, said a careful reading of the data should have meant nobody was surprised.
So why were they? The action took place in the space of three days last month, with inflation figures on July 18, taking in the strong June retail sales numbers on the 20th and ending with gross domestic product data (and revisions to past figures) on the 21st.
The inflation number, which at 2.5% was above the 2% target, raised the starting point for the Bank’s new projections. The sales and GDP figures conveyed a picture of robust economic growth.
But in the middle, on July 19, we had the minutes of the MPC’s meeting two weeks earlier. This was a picture of serenity; inflation risks evenly balanced and nobody talking about higher rates. The problem was that this view was a fortnight old. Keynes’s famous maxim — “When the facts change, I change my mind” — applied to the MPC.
Does this mean we should never take any notice of the minutes or, for that matter, speeches by committee members? No, but according to the governor, the MPC is not in the business of giving “hints” or “steers”. Other central banks call it managing expectations, but at least we know where we stand.
Where do we go now? I argued three weeks ago that as long as “second-round” effects of higher energy prices were contained, as they have have been on wages — pay growth remaining astonishingly subdued — the Bank could stand pat. I did, however, point out a fortnight ago that the decision was too close to call and that nobody should be surprised by a rise (though they were).
That is water under the bridge. Built into the Bank’s new forecast is what Sherlock Holmes might have called a 5% solution. If base rate rises to 5%, in line with what the markets were expecting when the new quarterly forecast was put together, inflation will gradually head back to the 2% target.
It may be a bumpy ride. King gave notice that there is a 50-50 chance that inflation goes into “letter-writing” territory over the next six months — in other words rises above 3% and requires the governor to write a public letter of explanation to Gordon Brown. If that happens, then for presentational reasons the rise to 5% could come before the end of the year and there will be pressure for more.
We have been here before, and each time a letter has been threatened, events have conspired to head off the danger. This time part of the risk comes from the way the Office for National Statistics decides to treat university top-up fees when they are introduced this autumn. As with energy prices, that is outside the Bank’s control, and outside the influence of monetary policy. But central bankers are human, and a missed target hurts.
If 5% is all it takes, I for one would not have too much trouble with that. It would exert a calming influence on consumers and the housing market, without doing serious damage. It would be in sharp contrast to past responses to soaring energy prices. It would be a gentle touch on the interest-rate tiller.
But these are, as King said, times of unusual uncertainty. What would I worry about if I were sitting on the MPC? Not about strong growth in the money supply, M4, which appears distorted by lending to the financial sector. The main concern would be, as last year, the coming pay round. Whether consumer price inflation tops 3% in the coming months, inflation on the tried-and- trusted retail prices index, which will be boosted by this month’s and any subsequent rate rises, could touch 4%.
Wage bargainers will have to be even more saintly.
It is important to recognise, however, there are risks in the other direction. The doves have not entirely flown the cote. Global growth is enjoying its strongest sustained run for more than three decades, and the Bank expects it to moderate only slightly. It is possible the American-led world economic slowdown will be more pronounced than this. Nouriel Roubini, professor of economics at the Stern School of Business, New York University, sees a 70% chance of an early American recession.
At home, there is a big question mark over the amount of spare capacity in the economy. Unemployment is at its highest for six years and has risen by 223,000 in the past year. Taken together with subdued wages, that suggests a lot of spare capacity.
But the Bank, in bolstering the case for higher rates in its inflation report, argued that the economy is actually quite close to capacity limits, largely based on the results of business surveys. If the labour-market figures are a better guide, as they have been in the past, that would suggest the MPC is worryingly unnecessarily, and that wages will continue to behave benignly.
There is another bit of the Bank’s analysis I find unconvincing. Inflation would have risen further on the back of higher energy prices, it says, were it not for those subdued wages and the fact that companies have been prepared to absorb higher costs at the expense of profit margins. Therefore, the danger is that when energy prices fall, firms will seek to rebuild those margins and may relax their grip on wages. With the 2% official inflation target governing behaviour, the risk is that a fall in energy prices will not lead to much of a fall in inflation.
But why? If energy prices fall, firms will not suddenly stop cutting costs. Because their profit margins will automatically recover, they will not need to raise prices. As for wages, the time of maximum danger is when energy prices are pushing up inflation, not when they are falling. This seems to be a phantom danger.
As I say, if 5% is the outcome, fine. If August 2006 turns out to be like the Augusts of 2005 and 2004 — one move followed by a year of inactivity — fine too. The risk is that the Bank talks itself into an inflation problem that isn’t really there, and then has to deal with the consequences.
PS: Long-standing readers will be aware of my skip index, a usually- reliable economic indicator based on the number of builders’ skips in my street. Zero means recession, two is roughly normal, four represents a boom. There are three at present.
Now I can report a new development — the scaffolding index. There has been a recent outbreak of scaffolding being erected outside ordinary family homes. Some of it is understandable; if you are having a new roof or converting a loft it is vital. But some of the scaffolding is going up for jobs where a ladder would have done in the past, such as painting the window frames.
I can’t tell if this is due to safety rules or a new kind of oneupmanship, in which scaffolding becomes a symbol of financial virility. But I will be monitoring this one closely in the coming months. One thing I have noticed about scaffolding, though, is that once up, it tends to stay up — often for months. So perhaps it is not the most timely indicator.
