Let's twist again

As usual, the latest edition of the Bank of England's quarterly Inflation Report contains a mixture of bad news and good news. The bad news is that it now looks inevitable that the Bank base rate will rise once more before the end of the year to reach 6%. The good news is that it does appear that this will be the last increase in the current cycle.

Despite this, there is little indication of an early cut in rate. Rather, it looks as though the base rate will be held at 6%, at least until the middle of 2008. However, it is most unlikely, even with interest rates held at these comparatively high levels well into next year, that there will be a collapse in the housing market. But the bad news is that a slowdown in UK demand over the next twelve months now appears inevitable, and the housing and mortgage markets will bear their share of this slower growth.

It is not unreasonable to ask why the Bank of England is more gloomy about prospects in its latest assessment of the economy than it was three months ago. After all, in May the Bank was expecting inflation would be brought under control with the base rate peaking at 5.75% and with economic activity largely maintained at around its trend rate. Now, not only are rates expected to be 25 basis points higher, but the Bank is forecasting a more noticeable slowing in demand.

The simplest excuse is that demand in the global economy has proved even more buoyant than had been expected. This has had two effects on the Bank's revised forecasts. First, the overall level of activity in the economy has been supported by a higher level of export demand. Second, and more significantly, faster growth has raised world commodity prices - most notably the price of oil which, at around $75 a barrel, is some $10 higher than it was three months ago. Unless oil prices soften, these higher costs are bound to feed through into higher UK prices.

However, the main difference between the Bank's May forecast and its latest view appears to lie in its increased conservatism, reflecting the concerns of the 'hawks' on the Monetary Policy Committee about the longer term prospects for inflation. The Inflation Report continues to stress the view that, in spite of the increases in base rate since August last year, the risks to the inflation forecasts remain to the upside. This, in turn, reflects the hawks' key concern that there are significant capacity constraints within the economy as the growth rate continues to run above trend, and that such constraints must be expected to be accompanied by increased costs and a tendency for businesses to raise prices.

Assessing risk

The key risk to the economy lies in judging when, and to what extent, the increases in base rate over the past year will affect domestic demand. So far, the resilience of consumer spending in the face of these increases has been very surprising, particularly given the subdued growth in real take-home pay. Partly, this may reflect the delay in the pass-through of the higher base rate into the retail interest rates that households face due to the relatively high proportion of borrowers on fixed rate mortgages and to the willingness of lenders to compress margins. Partly, it also reflects householder's willingness to support spending out of savings.

But none of these factors can be more than temporary. The Inflation Report notes that retail sales growth slowed in the second quarter, there are signs of easing in the housing market and the Bank's regional agents have begun to report that spending growth may have started to ease. For the hawks, next year will see a slowing in consumer spending, but 'nothing terribly dramatic'. But the 'doves' on the MPC fear there is a significant risk that consumption and domestic demand will slow much more sharply than the Bank's central projection suggests. n