As noted in August, the Bank of England’s latest Inflation Report appears to have been unduly pessimistic about the prospects for UK inflation and somewhat optimistic about the outlook for growth. The implication of these assumptions was to reinforce the view that the Monetary Policy Committee (MPC) was adopting a markedly hawkish stance.
Mervyn King appears to have further confirmed his hawkish prejudices in the tone of his open letter to the Chancellor, in which he explains why the inflation rate remained more than one percentage point above the 2% target. First, although acknowledging that the current high rate of inflation is due to temporary external factors rather than a generalised increase in prices and wages, King emphasises the expectation that “inflation is likely to remain markedly above the target until well into 2009”.
Second, he notes that “there continues to be evidence from surveys and financial markets that higher inflation has raised expectations of inflation, at least in the near term”. Third, while the outlook for demand has weakened noticeably over the past three months, King follows the Inflation Report’s optimism by judging that these adverse trends will, at least partially, be offset as “the depreciation of sterling will act to support output by stimulating net trade in goods and services”. And finally, he concludes that the MPC “has become firmer in its belief that a period of muted economic growth is necessary to dampen pressures on prices and wages (in order to) return inflation to target in the medium term”.
Now there would be few of us who would argue with this final conclusion. UK demand in the first half of last year was undoubtedly above its trend rate, with the result that supply constraints were beginning to make it easier for firms to push up prices. But the key question of how much of a slow down in output is necessary to achieve this objective is one which generates significant disagreement.
At the extreme dovish end of the spectrum, we have MPC member David Blanchflower, arguing that the economy is already set to decline more than enough to slow inflation down. As the Minutes of the MPC meeting paraphrase Professor Blanchflower’s argument: “the prospects for UK demand (have) clearly worsened over the (past) month, increasing substantially the downward risk to inflation in the medium term. There was no evidence that inflation expectations were pushing up nominal pay growth (and) the slowdown might be amplified by financial institutions’ responses to increased financial fragility”.
Hawks and doves
For the majority of the MPC, however, the economic data of the past month had raised the upward risks to inflation as well as increasing the downward risks to growth, leaving the assessment of the medium term outlook for inflation unchanged from the August Inflation Report, thus allowing the hawks to argue that an early reduction in base rate might signal a slackening in the MPC’s commitment to meeting the inflation target.
However, there was some indication that some members of the MPC might be preparing to move from their hawkish stance. As the Minutes note, “it was more than usually important to stress that the Committee would continue to make its judgment each month on the basis of the changing evidence”.
It is perhaps not too optimistic to interpret this as an indication that some slight improvement in the prospects for inflation (such as the continuing fall in oil prices) or deterioration in the outlook for growth (higher unemployment, falling retail sales, further stress in the banking sector) would lead to a cut in base rate – probably not in October, but very possibly in November.
Where does this leave the mortgage market? In very indifferent health, I fear. The pressure on banks to restructure their balance sheets has materially increased. Cuts in base rate will now come too late to ease this process significantly. The extension of the Special Liquidity Scheme until January may provide a little more order to the current disorderly market conditions, but it will not materially increase the availability of mortgage funding. n
Peter Charles is chief econommist at Mortgage Express
