The BoE is in the horns of a dilemma

The Bank of England is meeting this week to deliberate on monetary policy, at a time when the UK economy looks to be slipping into a steeper downturn, while inflation is rising to new highs thanks to rocketing oil and commodity costs. It is only a few months since markets had been pricing in up to 3 further rate cuts this year, but that position was reversed when inflation bubbled back above 3% in April, then hitting 3.3% in May. The inflation rate is likely to register higher again for June when the numbers come out later in the month. Markets suddenly began pricing in rate hikes over the past month with many analysts predicting it would come as soon as this week. But in the past fortnight economic data has revealed an acceleration in the downturn of the UK economy, with the manufacturing, services and construction sectors all contracting in June, while confidence amongst consumers and businesses alike are at rock bottom. It is difficult to see how the Bank of England can raise interest rates against this backdrop, unless they wish to push the economy into an even sharper downturn and into recession.

The Governor Mervyn King has recently admitted that rising inflation is owing to spiralling costs of imported oil and commodities and short-term adjustments in interest rates is not going to alleviate this problem. What the Bank will need to determine is if an interest rate hike would be successful in anchoring inflation expectations and might ward off potential second round effects, where unions are demanding higher wages from employers. But with economic growth grinding to a halt, it is likely the labour market will soften over the next 2 quarters and wage inflation should not be an issue. Also, while inflation may rise higher in the coming months until such time as there is a stabilisation or a decline in commodity costs, inflation should moderate accordingly from the middle of next year. Indeed there is every prospect that commodity prices could collapse, given the stagnant state of the global economy and in this situation inflation could begin to decline sharply from the middle of next year. It would be totally irresponsible of the MPC of the Bank of England to raise interest rates to combat an inflation threat they largely have no control over. Indeed the MPC would be better served to coordinate actions with other major Central banks who find themselves in exactly the same dilemma. The diversification in polices of the ECB and the Fed serves to remind us no coordination currently exists.

The ECB went it alone and decided to raise interest rates last week, but economic data from the euro zone in the coming months could indicate that the ECB’s decision to tighten now was a huge mistake. In any event recent economic data out of the euro area has not been as soft as that out of the UK, while the euro economy significantly outperformed the UK economy in the first quarter of 2008, the last period for which comparative GDP data is available. Therefore, the Bank of England is not under undue pressure to follow the precedent set by the ECB.

The Bank of England is clearly not in a position to raise interest rates in the current climate and in fact there should be considerable more airing for an argument to cut them this week, than there was a month ago, even allowing for the subsequent rise in consumer price inflation. It seems certain rates will be kept on hold, given all of the risk and uncertainty currently surrounding growth and inflation. A brave decision would be to take a leaf out of the Fed’s book and to cut rates, to help stimulate growth at a crucial time for the economy, on the assumption that longer run inflation will be forced to moderate anyhow as the economy slows. Either way, markets should be on the lookout for comments from Bank of England committee members in the days after the meeting, because business and consumers alike will be looking to the Central Bank for some words of wisdom or reassurance, at a time when economic growth is deteriorating at an alarming pace. It is not beyond the bounds of possibility the MPC will break with normal tradition and issue a more detailed statement this week, even if rates are kept on hold, in an attempt to more promptly address growing fears about the state of the economy.

Sterling should continue to hold its own against the euro and the dollar, trading within recent ranges, while markets continue to rule out the possibility of rate cuts. But any sustained move against commodities will tend to undermine the pound because a relaxation in energy and food costs would make the Bank of England a certain candidate to then ease its monetary policy in the months ahead. This week’s MPC meeting could prove to be a non-event for the currency, if, as expected, rates are left on hold and the Bank does not issue any detailed statement. There is serious downside risk for the currency over the medium to longer term.

Ted B - Jul 8