The British economy is now operating in a totally different financial environment from anything seen in the past 50 years. Or it will be, I should add, if, as expected, the Bank of England announces a cut in the base rates from 4.75% to 4.5% on Thursday 4 August. The significance of this event will go well beyond the direct economic impact of a quarter percentage point cut in mortgage rates.
An easing of monetary policy would imply that the UK interest rate cycle peaked in the present interest rate cycle at 4.75%, the lowest interest rate peak for 52 years. Just a decade ago, this would have been unthinkable. Indeed, this peak would be lower than the interest rate troughs of every interest rate cycle between 1964 and 2001. How our economic environment has changed. But more of that later.
A rate cut is coming – and the City knows it
The Bank of England, which is the master of managing market expectations, has been gently steering the City to its rate-cut conclusion for the last couple of months. Back in May, its Governor, Mervyn King, said that he was ‘surprised’ at the speed of the slowdown in retail spending. On 9 June, at the Bank of England’s Monetary Policy Committee (MPC) meeting, two members, Charles Bean, the Bank’s chief economist, and Marian Bell, voted for such a quarter percentage point rate cut. This was, in fact, the first time any MPC member had endorsed monetary easing since July 2003.
The minutes of the July MPC meeting released on Wednesday reveal that now four out of nine MPC members favoured a quarter percentage point cut in rates. These members were Kate Barker, Charles Bean, Stephen Nickell and David Walton (who has replaced Marian Bell). This news has effectively teed the markets up for a rate cut in August. Indeed, there may have been a cut on 7 July were it not for the London bombings. In the event, the decision not to reduce rates on that day was wise: cutting rates when the London transport system was paralysed would have added to the sense of panic and would have given the bombings an exaggerated economic significance.
How the Bank will justify easing
So is a rate cut warranted? Until recently, the Bank had hoped that export growth would fill the void left by a slowdown in consumer spending. But the growth of overseas demand has been more hesitant than expected, particularly in the EU, where 52% of UK exports of goods and services headed to last year. Italy is in recession and Germany’s domestic demand is flat.
As a result, the UK economy has grown by only 2.2% in the last four quarters, which is below the sustainable trend rate of growth of 2.5% to 3%. Meanwhile, unemployment has risen marginally in the last six months; more worrying, the only net new jobs created since 2001 have been in the public sector.
If weak demand is the main pretext for monetary easing, it is low inflation that gives the Bank of England the freedom to act. Although the new official index of consumer prices rose to 2% in the 12 months to June, the highest rate for seven years, this was blamed on the rising prices of seasonal foods, which will be unwound in the coming months. Indeed, the Bank of England sees its 2% inflation target as ‘symmetrical’, meaning inflation below the 2% threshold is as much a concern as inflation above it. The European Central bank should take note!
But something has changed. When, in previous economic cycles, the economy was running at close to full employment, inflation pressures would be far more pronounced, and the authorities would be considering rate hikes rather than rate cuts. So how is it that the Bank of England has such room for manoeuvre, surely so envied by previous policymakers?
Secrets of economic success
In recent years the UK economy has benefited from three influences. Firstly, some of the countries from which the UK imports have experienced extraordinary rates of productivity growth. This has allowed countries such as China and India to reduce the prices of goods it sells to us. Falling import prices not only provide cheaper goods on the high street but also increase the competitive pressure on domestically produced goods, keeping inflation low. This leads us on to the second influence.
While falling import prices have meant that UK consumers have more money to spend on other goods and services, we have maintained the pricing power in the knowledge-based services Britain specialises in and exports. This windfall for the British economy, known in economics jargon as an ‘improvement in the terms of trade’, has enabled consumption to rise faster than national output. But in the last two or three years this helpful influence has been less marked and, partly as a consequence, consumer spending in the UK has moderated.
The third influence has been the arrival of huge numbers of migrant labour into the United Kingdom. Increased labour supply has kept wage costs in check at a time of near full employment. Comprehensive and accurate numbers on the scale of this influx are not known. However, the Home Office estimates that between May 2004 and March 2005 around 120,000 workers entered Britain from new member countries of the European Union. That is not far short of the average annual increase in the labour force over the past decade. Take away these inflows plugging the skill gaps in our tight labour market and there will be huge upward pressure on wages, leading ultimately to higher inflation.
It is these three structural changes to the UK economy that allow the Bank of England the scope to steer the economy at much lower interest rates than hitherto imagined. If rates do indeed peak at 4.75%, this should boost flagging consumer confidence. The chances that the housing market will have a cushioned landing are enhanced, while consumers have a temporary reprieve from their worries about excessive borrowing. Yet a reduction in interest rates is not without considerable risks.
Our good luck cannot – and won’t – last forever
There is serious doubt as to whether the three structural factors that have kept inflation low will continue to work their magic. An interest rate cut and the prospect of further easing will undermine the attractions of the pound on the foreign exchanges. A weaker sterling leads to a rise in import prices. In fact, we are seeing evidence of this already.
So far this year, the price of a barrel of oil has increased from $40 to $60, an increase of 50%, but the sterling price of oil per barrel has risen from under £21 a barrel to over £34 a barrel, an increase of 62%. And don’t forget that the Chinese Renminbi is pegged to the dollar – so the sterling price of Chinese imports has also gone up.
Higher import prices, in turn, eat into the real disposable income of British consumers, negating some of the beneficial effects of lower interest rates. And you cannot expect the flood of labour from Eastern Europe to continue at its current pace.
Meanwhile, the UK economy is awash with money. In the six months to May this year, the stock of broad money climbed at an annualised rate of 14.3%, the highest figure since the mid-1990s. This money has to go somewhere – and it’s going nearly everywhere.
The last few quarters have been very good for a range of assets, with the major exception of residential property, which was due a breather in any case. Share prices in the United Kingdom are about 20% higher than they were a year ago and UK government bonds have continued to appreciate. Corporate earnings are doing well, because oil and mining stocks have benefited from the surge in oil and metal prices. Banks have been willing to lend aggressively to private-equity houses, which, in turn, push up the share prices of their prey.
In short, the asset price buoyancy of early 2005 is a direct by-product of high money supply growth. And lower interest rates will serve to fuel this development. In fact, the only area where strong money supply growth has not pushed up prices is on the High Street – yet.
Enjoy the ride while it lasts
An extended boom in asset prices and a weaker pound present a potential for inflation to get out of hand in the next 18 to 24 months. If the magic of the British economic miracle wears off, the next peak in interest rates may have to be higher than the last one. In the meantime, our advice is straightforward. A combination of interest rate cuts and strong money supply growth will help underpin gains in UK shares, so enjoy the ride for a while longer.
However, any rebound in mortgage borrowing and the housing market will be a suckers’ rally. Avoid the temptation to take the plunge. Longer-term, the Bank of England will have to be very skilful and very lucky to sustain the British economic miracle that has lasted since 1992.
Brian Durrant is the Investment Director of The Fleet Street Letter.
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