David Hillier: All the signs show it's looking up for growth. Expect the cost of borrowing to do the same

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This Wednesday, we'll get an update on the thoughts of the Monetary Policy Committee (MPC) on growth and inflation, when the Bank of England publishes its quarterly Inflation Report. The tone of this will give us the best "steer" on where interest rates are heading over the next few months.

This Wednesday, we'll get an update on the thoughts of the Monetary Policy Committee (MPC) on growth and inflation, when the Bank of England publishes its quarterly Inflation Report. The tone of this will give us the best "steer" on where interest rates are heading over the next few months.

When the last report was published in November, I was surprised by its pessimistic views. Although its forecast showed inflation at the 2 per cent target in two years' time, the "commentary" that accompanied this projection was incredibly downbeat.

To start with, the report said that the risks to the MPC's inflation and growth projections were "somewhat to the downside". In the previous three reports, the risks to both had been described as "balanced". That might not sound like much of a change, but a switch of this nature would normally lead to a rate cut of around 0.25 per cent (see the first chart on the right).

That message was supported by the probability attached by the MPC to an overshoot of the inflation target at the important two-year horizon. In November, the MPC was so nervous about the economic outlook that it assigned a probability of only 40 per cent to such an out-turn - the lowest probability that the MPC has ever given to an overshoot of this type (see the second chart).

That's right, three months ago, the MPC thought there was less chance of inflation overshooting the 2 per cent target rate than in late 1999, when the global economy felt like it could very well be on the point of collapse after the Russian bonds crisis, the emerging markets crisis, and the collapse of high-profile hedge funds.

Given this, it wasn't too much of a surprise that some MPC members were thinking about a rate cut in December. Indeed, the second chart shows fairly clearly that when the MPC thinks the probability of a two-year overshoot is that low, it generally leads to a rate reduction of around 1 per cent over the next three months.

But that, of course, is not what happened. Interest rates have not been cut. Indeed, financial markets are now getting close to pricing in an increase. That's partly because the minutes of the January meeting of the MPC said that the downside risks to the inflation forecast that were outlined in November had not materialised. They also said that stronger-than-expected inflation out-turns meant there was a need for the inflation forecast to be reassessed. Finally, and perhaps most telling, there wasn't any mention of interest rate cuts at all.

So, what happened? Why was the MPC so pessimistic in November, and why did this pessimism prove misplaced? The answer to the first question is probably that a much weaker-than-expected out-turn for gross domestic product (GDP) growth in the third quarter of 2004, combined with some sharp falls in key housing market numbers, "spooked" the MPC. So much so that it cut its GDP growth numbers quite aggressively.

I argued at the time that the reductions were far too harsh. The housing market was slowing, but in an orderly way, and there were important structural differences compared with the late 1980s that would prevent the market from collapsing. I also argued that, with the labour market tight, earnings growth fairly firm and debt more affordable than in the late 1980s, consumer spending growth would not fall back as sharply as the MPC appeared to fear. Fortunately for us, this view appears to have been correct.

Indeed, a range of numbers on the housing market suggests that the slowdown in activity has bottomed out. Meanwhile, the labour market has continued to tighten, so that earnings growth is now close to the maximum rate compatible with hitting the inflation target in the medium term.

Partly because of that, confidence has improved. And indicators of activity in all the most important sectors of the economy point to reasonable, if not stronger, growth over the past few months.

The only key number that doesn't really fit into our view of the world is the weak December retail sales figure. But anyone who knows the ins and outs of the sales numbers will realise that this reflects problems with adjusting for Christmas rather than underlying weakness in demand.

Given all this, it's not really surprising that the MPC appears to be moving, gradually, towards accepting the need for a further increase in interest rates.

All of this should be reflected in the Inflation Report that is released on Wednesday. Indeed, I expect the risks attached to the growth and inflation forecasts to return to "balanced", rather than being "somewhat to the downside".

Linked to that, I expect the probability attached to an overshoot of the inflation target at the two-year horizon to return to a more sensible level (say 50 to 55 per cent).

The act of rolling the inflation forecast forward a quarter should push it slightly above the 2 per cent target rate, but that will be offset by a stronger-than-expected pound.

That leaves the stronger-than-expected activity and price numbers. I think these should push inflation around 0.1 to 0.2 per cent above the target rate at the two-year horizon. This might not sound a lot to the uninitiated, but if it's right then it will mean that it's not a question of "if" interest rates will rise again, but "when". I still expect rates to rise to a peak of 5 per cent by May, and continue to think that the risks to this forecast are on the upside.

David Hillier is chief UK economist at Barclays Capital

Kyoto kickstarts revival in nuclear reactors

This week the clock starts ticking on the Kyoto agreement for limiting greenhouse gases. Whatever you think about Kyoto - it is too strong, too weak, targeting the wrong things, no use without the US being signed up, etc, etc - it is clear that it is going to make a big change to the business of energy.

According to the best calculations, the UK's drive towards renewable energy generation - through wind farms, biomass, wave schemes and the like - will not generate enough electricity to meet the Kyoto targets.

Yet the attempt will push up energy costs for business users and homeowners. The strong belief is that the British Government will bite the bullet and say it is going for a nuclear-reactor building programme - though not until after the general election as this is a pretty sensitive subject.

If Britain does go nuclear, we will be following a trend that's gathering pace around the world. Apart from in a few outposts - such as France, Scandinavia and Japan - nuclear has been off the menu for the past two decades. The accidents at Three Mile Island and Chernobyl created a climate of fear in which the idea of building new reactors could hardly be broached.

But, as Tim Webb reports at the front of this section, this is changing. China, which not only has the greatest need for energy but also some of the worst pollution in the world, is planning to build 40 new reactors over the next few years. These are not the big hulking things that you see if you pop down to Dungeness or Dounreay, but much smaller reactors, known as pebble beds.

These are supposedly safer (where have we heard that one before?), but because of their size they certainly do not need the big capital expenditure required for something like Sizewell B, the last nuclear reactor built in the UK. They can also be built small enough to serve a single city.

The US and South Africa are also looking at pebble-bed reactors, and it is a strong bet that we will too.

The effect of this potential nuclear building is to force up the price of uranium, which is nearly 50 per cent more expen- sive than a year ago. This makes the bid from the Swiss-based mining group Xstrata for Australia's WMC still more interesting, as WMC owns one of the world's biggest uranium mines. Another big uranium miner is our own Rio Tinto, which surprisingly has been out of favour with investors recently.

To misquote Richard III: "Now is the nuclear winter of our discontent/Made glorious summer by the Kyoto protocol."

Jason Nissé

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