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Thursday, 6 March 2008

Decisions decisions – the outlook for interest rates

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 stability.

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.

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posted by Carl Malways at | 0 Comments Links to this post