decisions – the outlook for interest rates, by Carl Malways
Today saw the Bank of England keep interest rates on hold at 5.25 per
cent, following a cut in February. Many people had been expecting this
decision given that all the signs are pointing towards a period of higher
inflation with both input and output prices rising, and commodity prices
hitting record highs.
The economy also seems to be weather the storm for now, reducing the
imperative for the Bank to cut rates immediately. Recent January retail
sales figures as well as improvements in both the manufacturing and
services purchase managers’ index indicated that the economy was
still expanded, and was not in a period of universal suffering. Most
significantly, the labour market has continued to perform well. Although
wage growth has been squeezed in both the public and private sector,
the number of jobs in the economy continues to grow, whilst the numbers
of those claiming unemployment benefits continue to fall.
Despite a selection of “good news” stories, the outlook
remains grim, and underlying problems are starting to show themselves.
As a result, the primary reason why the Bank of England didn’t
cut interest rates was because the short term outlook for inflation
has increased, stifling the Banks ability to pre-empt the slow down
in the UK economy. Inflationary pressures have been growing as a result
of rising energy and food prices. These are clearly outside of the control
of the Bank, which can now only hope for a good harvest, increased output
from OPEC and a more stable international commodity market.
Higher prices not only
reduce the ability of the Bank of England to cut interest rates,
they also squeeze the consumer. With consumers seeing food prices
rise by around 6 per cent over the past 12 months they have
been forced to reduce their spending on other items. The crisis
in the banking sector has seen lenders increase their margins
which has resulted in mortgage repayment rates remaining high,
despite the cuts in the base rate, resulting in mortgage interest
repayments rising by over 16 per cent in the past 12 months.
Household budgets have become increasingly stretched, and with
few savings the consumer is likely to cut spending on non-essential
goods over the rest of the year.
The housing market also continues to slow. According to both
the Halifax and Nationwide house price indices prices have fallen
in each of the past four months. Although this will not directly
impact upon those who are not moving house, those that do move
may face negative equity. The housing market has also allowed
many to re-mortgage and release equity in their houses over
the past two years which has helped to fund increases in spending.
With falling house prices and less capital to lend, the ability
to release equity is becoming increasingly difficult.
Another worrying sign is the revival of the
spread between Libor and base rates. Libor indicates the interest
rate that banks are willing to lend to one another. When there
is a lack of credit or banks are worried about the risk of lending
in the financial market, they will withdraw their credit, making
it increasingly expensive to borrow money – increasing
the Libor rate. The Libor spread had fallen steadily since the
start of the year, but with expectations of further losses in
the banking sector, it is once again increasing. This suggests
that the worst is not yet over in the banking market, and it
is far from getting back to a normal lending environment. As
a result banks will continue to charge higher interest rates
to both businesses and consumers.
So why hasn’t the Bank cut rates as rapidly as the Federal
Reserve? There are two reasons for this. On the one hand the
economy in the UK is not as bad as the US. The US economy has
seen much larger losses in both the housing market and the financial
sector. The economy appears to be shrinking and jobs are being
lost. The other reason is that the Bank is far more tied to
the inflation target of 2 per cent than the Federal Reserve
which has a broader remit to maintain economic and inflationary
Nevertheless the Bank will cut interest rates this year and
next. Inflationary pressures are likely to limit interest rates
in the next eight months. I would expect there to be just two
25bp cuts between now and September. However, as the economy
slows and prices fall, and the rapid rise in prices at the end
of last year fall out of the annual growth rate equation, the
Bank will have the scope to cut interest rates more rapidly.
I would expect further interest cuts at the end of the year,
with perhaps even a 50bp cut before the start of 2009.
I remain positive that the UK won’t enter a recession
in 2008, however, it will be a very tough year for many people
and things will get worse before they get better. I would not
be surprised to see unemployment start to rise in the next few
months and the claimant count could well rise past one million,
up from about 850,000 at the moment. With higher unemployment,
wage growth is likely to remain low, and bonuses are unlikely
to look particularly healthy. Expect plenty of disappointment
in 2008, with fewer jobs about, lower wages and more stress
its not going to be the nicest place to have a job – but
it’ll be far better than having no job at all.