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Thursday June 23, 2005 - 13:44:07 GMT
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Pressure for UK rate cut

The Bank of England will want to see a controlled slowdown in the UK housing sector and will not, therefore, want to ease monetary policy too quickly, especially as this could exert fresh upward pressure on asset prices and revive credit demand. The bank will also be wary of bowing to pressure from the retail sector for lower interest rates.

The bank will certainly be concerned over a slowdown in consumer demand and the risks of a sharp retrenchment in spending if fears over debt levels prompt a sharp drop in credit demand. This will be a particular risk if there is a significant rise in UK unemployment. The bank will, however, also keep a close focus on import prices, especially if oil prices remain high and Sterling weakens. Given these pressures, the bank is likely to face a difficult balancing act over the second half.

Overall, the Bank of England is likely to keep rates on hold in the short term. There is, however, the potential for a cut late in the third quarter, especially if there appears to be a slowdown in global growth.

Market expectations intensify

Expectations of a further increase in UK interest rates faded decisively early in the second quarter of 2005 and the most recent data has reinforced the shift in sentiment with increased speculation over a near-term reduction in rates. The speculation has been increased further by the latest Bank of England monetary committee minutes which recorded that two members voted for a cut at the June meeting. Bank of England chief economist Bean and MPC member Bell both called for an immediate reduction in rates to 4.5%.

Consumer spending slows

The latest figures on consumer spending have been generally disappointing and suggest a significant downturn. Although there was a small recovery in the monthly figures for May, the annual growth rate still slowed to the slowest rate for six years at below 2.0%.

The latest evidence on house prices suggest that prices are broadly static on a monthly basis while transactions have declined. The annual increase in prices has slowed considerably to the lowest level for five years and it may only be a reluctance to accept lower selling prices which is preventing a more significant decline in prices.
The latest data recorded a second successive monthly increase in unemployment and earnings growth remains under control. The industrial sector remains very weak with orders deteriorating again in June and the overall evidence suggests that growth in the economy is slowing. The latest government borrowing figures were significantly higher than expected and this will raise concerns that the economy is being supported more than expected by government spending.

After a net credit repayment in April, there was a small increase in credit-card borrowing for May, but there has been a significant overall slowdown in borrowing. Employment levels are still strong enough to support the economy, but there will be concerns over debt levels. A sudden loss of confidence in the levels of debt could force a sudden retrenchment in borrowing and a downturn in consumer spending. Given the dynamics of high debt, only a small increase in unemployment could trigger a rapid adjustment in spending levels. In these circumstances, the bank would need to act quickly to prevent a serious downturn.

Wariness over inflation

The annual inflation rate was unchanged at 1.9% in May, just below the 2.0% Bank of England target. Earnings growth is under control, but the bank will still have some concerns over the inflation outlook. The renewed increase in oil prices will put upward pressure on prices and the UK currency has also weakened against the dollar which will increase the risk of rising imported inflation. Bank of England Governor King has also warned that rising import prices are a concern.

The Bank of England will also be a keeping a close eye on wider import prices, especially as Sterling has weakened to near 1.80 against the dollar from levels above 1.90 early in the second quarter.

Reluctance to over-react

The Bank of England raised interest rates in the first place because of concern over rapid house-price inflation. It will, therefore, be very wary of cutting rates too early as this could put fresh upward pressure on prices and magnify the longer-term market distortions caused by strong asset-price inflation. The bank would, therefore, probably prefer to maintain stability in the short term. Nevertheless, the bank is likely to face a very tough balancing act over the second half of 2005 with little margin for error.

Global trends could be significant

The Swedish central bank has cut interest rates by 0.5% to 1.5% and the ECB is also under pressure to cut interest rates. The level of European rates should not have a major impact on the Bank of England, especially with Sterling not part of monetary union. Any trend towards lower interest rates in Europe would, however, make it easier for the Bank of England to cut UK rates. Similarly, the central bank will be more comfortable cutting rates if it appears that US short-term rates are close to peaking.

 

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