In the wake of confirmation that the Bank of England’s Monetary Policy Committee (MPC) voted by what was the narrowest of margins (5-4) at its January meeting, to push UK base rates to 5.25%, sterling’s sharp about-turn from a new 14-year high against the dollar (coming within a whisker of $2 / £1 at $1.9918 at one point on Tuesday 23rd January) encouraged many financial market practioners to take the view that the Bank had indeed acted with intemperate haste. We do not agree.
The Minutes of the January MPC meeting were accompanied by the first stab at UK Gross Domestic Product (GDP) growth over Q4 2006 which showed activity accelerating by a better than expected +0.8% quarter on quarter (forecast +0.7%), for 3.0% annualised and average growth for 2006 as a whole emerging a little above the 2.0%-2.5% long-term trend rate at 2.7%. In our view the psychologically important $2 / £1 is still a distinct possibility in the medium term although short-term trading is as likely to be dominated as much by sentiment surrounding the US Federal Reserve’s 31st January meeting as the aftermath of continued obfuscation from the Bank of England.
MPC base rate decision: what the voting tells us
Perhaps the most interesting thing about the MPC vote over January was the extent to which Bank governor Mervyn King’s “praetorian guard” cleaved in two. During the previous governor’s (Eddie George) tenure it was he himself who voted last. If the same holds true today then the governor will have made the casting vote, significant (in our view) given his long-term hawkish tendencies and justifying the front page headline in the Financial Times on the day the decision was confirmed. Notable amongst the dissenters were independent member David Blanchflower and Bank
deputy governor Rachel Lomax (both of whom voted against the previous 0.25% pointincrease in November) but, most interestingly, Bank chief economist Charlie Bean and executive director of markets Paul Tucker. The latter may have felt that to move base rates in a far from boring decision in the immediate aftermath of the festive season with just the following week’s CPI data to go on might have added to financial market volatility.
The MPC minutes
The minutes indicated that all nine MPC members felt that the balance of inflation riskhad moved to the upside, no great surprise given the 3.0% inflation rate and concerns regarding the possible inflationary consequences of the forthcoming pay round, but that considerable debate took place as to whether the blizzard of recent domestic economic data was, itself, sufficient to justify pushing rates up outside a quarterly reforecast month (the first time this has happened for two and a half years). The statement accompanying the January rate hike surprised only in that the justification seemed so non-specific to the present time. The Bank has been warning regarding the possible inflationary consequences of rising asset prices, money supply, credit and robust global and domestic economic activity, together with the inevitable, if hard to measure, closure of the output gap for some time. In the view of the Committee there remains a significant risk that inflation might not fall back towards the targeted 2.0% in the prescribed two-year time frame and little risk that by pushing base rates ahead by a further 0.25% that growth might be derailed.
The Medium-Term Outlook for UK base rates
The Wednesday Jan 24th FT article indicated that Mr King had hinted that the process of monetary tightening (within which base rates have been hiked by 0.75% points since last August) might be coming to an end. Speaking to the Birmingham Chamber of Commerce, he suggested that ”The Committee’s central view remains that inflation is likely to fall back in the second half of the year, possibly quite sharply”.
In part, the justification for that view comes from the strength of the pound on the foreign exchanges. The close correlation between sterling’s strength and the level of export orders does indicate that, were the currency to maintain its poise on the foreign exchanges and US economic activity to weaken, as we suspect that it will, the export sector could be in for a nasty shock, adding downward aggravation to a domestic
economy likely to show clear signs of buckling under high levels of domestic debt and higher taxes as the year wears on.
The short-term outlook for UK base rates
In the near-term we do not believe that the Committee will be put off from raising base rates again by sterling’s toying with $2. Economists have already noted that, other than the psychological significance of $2 / £1, the physical level makes nodifference, in itself, on the real economy (i.e. no different to $1.98 or $2.02). They might also note that sterling’s strength has, in large part, been driven by the financial markets’ anticipation of rate hikes to come.
Secondly, investors should look beyond the relationship between sterling and the dollar and focus instead on sterling’s trade weighted performance (against a basket of currencies). When viewed on this basis investors can see that, at around 107, the pound is about 3% ahead of the level used in the November inflation forecast (see chart below). This is not an insignificant appreciation but equally, it is probably not enough in itself to have a major impact on the Committee’s deliberations.
UK base rates – where next
In the immediate aftermath of the January rate decision financial markets were tempted to take the view that the Bank had brought forward the February rate hike (as forecast in short sterling futures pricing) to influence the January pay round. The result of the publication of the minutes, and close nature of the vote, has further convinced markets that the peak in the monetary cycle might have been reached. We are less convinced. Real economic activity appears buoyant, underlying inflation remains stubbornly above the Bank’s comfort level, the CBI’s Industrial Trends survey indicates that, for now, export orders remain intact, money supply continues to grow and consumer spending patterns indicate an indifference to base rates at prevailing levels. In these circumstances the Bank may wish to fire another shot across the bows of pay negotiators at its February meeting. In conclusion we do see sufficient scope to push rates higher by a further 0.25% points soon if not, perhaps, next month. Mr King’s comments do, however, add to our conviction that UK base rates will be on a downward path by the final quarter of 2007.
By Jeremy Batstone, Director of Private Client Research at Charles Stanley