With the credit crunch now taking second place to worries about inflation, interest rate futures are pointing to significantly higher official UK interest rates in the next two years. This is a sharp turnaround from a few months ago when they were looking for deep cuts. But the rise in consumer price inflation to 3.3% in May and the prospect that it will peak at well over 4% this year has led to a sharp change in sentiment in the financial markets. Moreover, UK consumers seem immune to the pressure from rising inflation, higher mortgage borrowing costs, falling house prices and lower confidence.
Scenarios highlight risk of UK recession
Credit crunch taking second place to worries about inflation…
With the credit crunch now taking second place to worries about inflation, interest rate futures are pointing to significantly higher official UK interest rates in the next two years. This is a sharp turnaround from a few months ago when they were looking for deep cuts. But the rise in consumer price inflation to 3.3% in May and the prospect that it will peak at well over 4% this year has led to a sharp change in sentiment in the financial markets. Moreover, UK consumers seem immune to the pressure from rising inflation, higher mortgage borrowing costs, falling house prices and lower confidence. Retail spending refuses to fall, rising by 3.5% in May to stand 8.1% higher in volume terms than in the year before. Our view is that employment growth is the key to this and as some people give up on owning a home, or moving near term, and spend instead, leading to lower savings and strong growth in sales.
…this could lead to higher interest rates…
With inflation rising, there is a clear risk that the MPC may be forced to raise official interest rates significantly higher, despite weaker overall growth. Because of this, we have calculated two scenarios, one where interest rates move in line with financial market expectations, as suggested by forward sterling interest rates, and a second where Bank rate is 2% higher than in our base case. The base case assumes only one increase in UK official interest rates, in early 2009 when the effects of the credit market crisis are fading and the implications of higher consumer price inflation for the economy are clearer. The results of this exercise are shown in the following charts. And the outcomes are clear: the Bank of England must be careful not to raise interest rates too much too soon. Such an outcome could make the unfolding economic slowdown too excessive, and lead to consumer price inflation undershooting the official 2% target in 2010. At the same time, our analysis shows that some increase in official interest rates seems necessary for inflation to hit the 2% target. But for that to happen, a period of below trend growth (2.3-2.6%) this year and next is inevitable.
…but our scenarios show that excessive rate hikes could lead to recession and inflation undershooting the target in 2010…
UK economic growth would slow to just 0.8% in 2009 if base rates were raised to 5.75% by September of this year. If base rates are raised by 200 basis points, i.e. to 7%, the UK would experience recession in 2009, see charts. That sets the limits for any rise in UK Bank rate, with anything above 1% likely to cause severe economic
dislocation. This is in line with the analysis we did in 2007, which showed that UK Bank rate above 6.5% would lead to a contraction in economic output. One reason is that with UK households highly indebted a rise in base rates would raise repayment costs to such high levels that consumer spending would be cut back dramatically and consequently growth would fall back sharply, see charts. Another reason is that manufacturing output would also fall, leading to a decline in profits, lower investment spending and sharply lower employment. As this process takes hold, a vicious circle develops with further cuts in consumer spending as rising unemployment combines
with significantly weaker earnings growth.
…so the MPC needs to tread very carefully in raising Bank rate
This latter position would be in sharp contrast to the present situation, where it is rising employment that seems to be one of the main bulwarks against recession, as it keeps total employment income rising, even as inflation erodes real spending power. Of course, if unemployment rose then house price falls and mortgage arrears would ratchet very sharply, alongside higher company default rates. But, as chart h shows, with Bank rate at 5.75% through to 2010, the inflation target would be sharply undershot. And if rates were raised by 2 percentage points to 7%, there would be falling prices. The MPC would be far too aware of this risk to allow it to happen, (Japan is a lesson to all) so one would realistically expect official rate cuts to be taking place as early as February of next year if they were indeed raised too high this year. This is one reason why we believe that rate rises this year, and especially to the extent that financial markets expect, are too excessive. A modest rise in rates, of perhaps 0.25%
or 0.5% some time in early 2009 would be sufficient to bring consumer price inflation back to target in 2010. Moreover, our analysis also shows the futility of any attempt by the authorities in trying to get inflation back to the 2% target in 2009. All that happens is an excessive slowdown that actually does not even get inflation back to 2%, or
below, in 2009. Inflation is set to fall back to target in 2010 – and to stop it from falling below target the MPC should not overdo rate rises this year. But the analysis also shows that Bank rate can only be cut from the current 5% if the economy is close to, or in, recession.
Chief Economist, Corporate Markets