The nervous autumn continues, with the rumble of thunder getting ever closer – though, as yet, no storm has broken.
Last week saw a large wodge of new information about the British economy. There was, most notably, the Bank of England's Inflation Report, which was spun into suggestions that there would be at least two cuts in interest rates in the early part of next year. There was also some more disturbing news about inflation, with the consumer price index back above the central point of the target range and the retail price index above 4 per cent again. Retail sales were off a bit, house prices do seem to be falling and the pound had a sharp and somewhat unexpected fall, particularly against the euro. There was also mixed information on the labour market and, as you might expect, confusing stuff about migration. So what was important and what was not?
For me the most disturbing news came on the inflation front – not just what seems to be happening but the Bank of England's apparent response to it. The problem starts with the divergence between the two main indicators, the consumer price index and the retail price index. The CPI is at 2.1 per cent, which sounds OK-ish in the light of the projected slowing of the economy next year. It is, after all, only a whisker above the mid-point of the range. But the RPI is 4.2 per cent, and that is troubling, for it suggests that this has become the level embedded in the economy.
The CPI is the rate used by the Bank and quoted by government ministers but it has virtually no other functions. Benefits are not linked to it; nor are pensions; nor is the rate of return on index-linked gifts; nor are a string of commercial contracts, alimony payments and so on. These are all linked to the RPI. As the Office for National Statistics points out, this is the most commonly used index for wage bargaining too. So the Bank operates on a statistical measure that has few practical functions, instead of the one that everyone else uses. Let's not go into the reasons, which have to do with harmonising with other EU countries, nor even which measure is intellectually more robust. (I would just say that my own preference is the RPIX – the RPI excluding mortgage interest payments, which was used by the Bank's monetary committee before it was forced to move to the CPI.) The main point is that the RPI is the one that matters, not the CPI, but it hardly gets a mention by the Bank in its report.
If the headlines were that inflation was now over 4 per cent and might well rise further, the idea that interest rates next year could fall would seem very odd. We don't know what the Bank's projections for the RPI are, but we do know the projections for the CPI. They are shown (on the sensible basis of market interest-rate expectations) in the right-hand chart. This is one of those fan charts which aim to show the mid-range of the Bank's expectations but also the less likely possibilities on either side of this mid-point. There is, according to these calculations, just a 10 per cent chance of inflation being outside the shaded range altogether. The centre point is below 2 per cent because these charts only take into account September results, the October ones only coming in a day before the report was published.
Now look at the mid-point. This seems to go up by about 0.25 per cent next year. We are a bit above the mid-point already, an earlier move than the Bank projected, so let's say the Bank expects CPI inflation at around 2.4 per cent next summer. That may not be right but it is plausible. What might its projection for the much-more-important RPI be? Maybe there will be some fall in mortgage interest rates by then, though the gap between the official base rate and what the lenders are actually charging on new mortgages has widened. Maybe global food prices will come down; maybe the oil price will come down. But it seems to me plausible that the RPI projection, if there were one, would have a mid-point of at least 4.5 per cent, maybe 4.75 per cent. That is not a great backcloth against which one could credibly reduce interest rates.
The problem would be further compounded were sterling to fall. The pound has been amazing stable since 1997, after it had recovered from the slump after its Exchange Rate Mechanism exit in 1992. The euro and the dollar have moved all over the place while the pound has remained in the middle. But just over the past few days it has weakened significantly, and I am not sure quite why. It has even fallen a bit against the dollar. Possible explanations include the market taking to heart the signals from the Bank that it might cut rates, rumours about the weakness of London banks, non-domiciled residents deciding to shift some money into other currencies and so on, but I don't think we really know. What we do know is that were the pound to fall much more that would feed some inflation into our system. We import a lot of stuff and we would have to pay more for it. Not good.
So, what about the slowdown? Well, here, rightly or wrongly, I feel a little more optimistic than the Bank seems to be, at least for the outlook next year. Things happen quite slowly and while the mood in the housing market has undoubtedly changed, that may not feed through into a consumer slump as some have feared. The US consumer took a long time to respond to falling house prices and there is a practical reason why we may not suffer such a serious dip in prices here. They have had a huge building boom; we have not. Employment is still strong and a slightly lower pound would help exports, particularly to Europe. We will see, but for the moment the Treasury forecast of growth of 2 to 2.5 per cent next year does not look too bad. At any rate I have not found a single projection of recession for the UK next year – and 2009, which might be a real problem, is still a fair way off.
Of course there are concerns, but it seems to me from the latest data that these should be about inflation rather than growth, at least for the first half of 2008. The growth phase of this economic cycle will eventually come to an end – but not just yet.Reuse content