Have UK interest rates peaked?
Mon, Nov 20 2006, 16:59 GMT
by Lloyds TSB Financial Markets Economic Research Team
Debate on next interest rate move not yet over
After the release of the November Bank of England Quarterly Inflation Report and the rise in base rates to 5% at the Monetary Policy Committee (MPC) meeting earlier in the month, the financial markets have lowered their bet that UK interest rates will rise in 2007. Other commentators have said that they believe that base rates have peaked at 5% and that the next move is downward. We think that this is a mistake, and with inflation still above target, money supply growth at a 16-year high, house price inflation accelerating and above trend economic growth, the Bank of England is more likely to raise interest rates one more time in this current cycle than not. However, it could be argued that the Inflation Report was more dovish than many had expected. Taking the market view of where UK base interest rates would settle in March 2007 prior to the Inflation Report and after its release shows that interest rates in the market are lower, see chart a. However, what is important to note is that this view of the likely direction of short term UK interest rates in 2007 still retains a bias toward base rates rising to 5.25%.
November Inflation Report more dovish?
The main part of the Inflation Report that caught the eye of many was that the MPC expects the inflation rate to get back to the 2% target six months earlier than in the August report and to be on or about the 2% target at the key 2- year period of the forecast, see chart b. This is interesting, since the latest Inflation Report also showed that economic growth is expected to be rather faster than in the August report as well. Reconciling faster economic growth with lower inflation in the new forecast implies that the MPC must believe that the UK’s trend or potential rate of growth (the rate it can grow without generating inflation) is now higher. Indeed, the November Inflation Report alluded to this by remarking that the rise in immigration and lower inactivity rates have increased labour supply. The MPC continues to expect consumer spending growth to rise in line with its historical average rate of 2¾% a year, but now expects business investment growth to be stronger than reported in August. Net trade is also expected to provide a modest contribution to output growth in 2007.
Inflation in November appears to contain more uncertainty than in August
The central view is that consumer price inflation will rise further above target in the near-term, before falling and staying at the 2% target over the forecast horizon. Although the MPC still believes that the margin of spare capacity within businesses appears limited, they note that unemployment continues to rise and that pay growth has remained muted, implying that there is still some spare capacity available. But they highlighted a number of key risks to this central view; rapid growth in money and credit, the outlook for wages, energy and import prices and the extent of spare capacity that there is in the economy. Overall, however, they report that the balance of risks to economic growth and inflation seem evenly balanced.
Interest rates to rise to 5.25%?
The key point we take from the report about the central projection is that inflation only hits the 2% target because the market implied interest rate contains a further 1/4% hike. Without this increase, reflected in the alternative forecast of 5% interest rates being maintained over the forecast horizon, inflation remains above 2% and does notfall back to target in the forecast period, see chart b. For this reason, amongst others, we continue to look for a further 0.25% increase in base rates in 2007, most likely at the February meeting, when more data will have been released and another Inflation Report is due.
Signs of strengthening growth and inflation pressures
The other factors that we think are key to this view that base rates may rise further, are the continuing strength of the housing market and its close link to retail sales activity, see chart c. The latter implies that economic growth is likely to remain above trend at a time when inflation is likely to remain above target. Chart d shows that our forecast is that consumer price inflation does indeed fall towards 2% in the middle of 2007, as the Bank of England expects, but then rises again in the second half of the year as economic growth remains robust. The other reason why we question whether inflation will fall back so quickly to target, and remain there, is the continued fast growth in money supply. As chart e shows, money supply growth and economic growth are closely linked, implying that growth should remain stronger than expected in 2007. This may put upward pressure on wage inflation, even though labour supply is rising. One reason for this is that the surge in immigration that forced a reduction in pay growth over the last 18 months is unlikely to be repeated to the same extent next year.
This is the key to the Bank of England raising base rates to 5.25% next year, in our view. It means that interest rates will not be raised just because economic growth is strong, but will depend on whether pay inflation stays below 4.5% a year. The Bank will keep a close eye on this and on inflation expectations, which our monthly consumer survey shows is beginning to fall back, see chart f, but remain quite high and suggest interest rates may have to rise further. In this situation, if pay inflation accelerates and consumer inflation does not fall back to target, and stay there, then interest rates may yet rise above 5.25% in 2007. Our central view, though, is that base rates are raised to 5.25% early in 2007, and so increases beyond this will not be needed. But if the MPC do not raise rates in February, they are taking a risk and may have to raise them by more later in the year.
