It is not a done deal because Mervyn King, Bank governor, speaking in Bradford earlier this month, was on a different tack. He put forward three reasons why inflation might surprise on the upside and only one reason for a downside surprise. Against the evident weakness of consumer spending, the governor cited rapid growth in household money, rising import prices and a tight labour market. In terms of the football metaphors that King loves, 3-1 is a convincing win, suggesting that he is far from ready to vote for a cut.
With Sweden leading the way with a surprise half-point cut last week, financial markets are convinced a quarter-point cut is coming here, probably by August, with a similar reduction at the turn of the year.
If markets are right that a cut is on the way, it is easy to write the statement that will accompany the move. On past form it would start with the global economy, move on to activity at home and make the case that the current pick-up in inflation stems primarily from transient factors.
On the global economy, the MPC’s statement might say that recovery has remained hesitant and that, although the conditions for recovery remain in place, the prospect for external demand for British output is weaker than expected.
The weakness lies in the euro area. Even before we see any fall-out from the stalemate on the constitution and the failure of the Brussels summit to agree a budget, GDP has slowed sharply. Growth in 2004, the strongest in the global economy for nearly 30 years, was a modest 1.7% and will be lower this year.
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Of the big economies, Italy is back in recession, while Germany is growing but only because of the strength of exports. Once again the euro economy is in a “soft patch”, one that is prompting the European Central Bank to consider lowering rates from the 2% level that it first set more than two years ago.
Against this background British exports have been doing as well as might be expected, particularly outside the euro area. But in reality the best we can probably hope for is that export growth keeps pace with imports; the downside risk is that net exports continue to act as a drag on the British economy.
On domestic activity, the MPC’s statement might argue that output growth has recently been below trend and that slower consumer demand and subdued private investment have so far offset the impact of higher public spending.
The MPC estimates that trend growth is 2.6% a year, or 0.6%-0.7% a quarter. In the first quarter of this year GDP rose 0.5%, a little below this rate, and 2.7% from the previous year, which is just above trend. On the new measure of “business output” that the Office for National Statistics (ONS) has developed at the Bank’s behest, growth slowed more sharply to 0.4% in the first quarter from 0.7% in the final quarter of 2004. In his Bradford speech the governor was able to make the case that the economy is growing at a rate not far from its long-run average.
The weakness is more obvious on the demand side, particularly spending by the private sector (see chart on left). Household consumption rose 0.2% in the fourth quarter of last year and 0.3% in the first quarter of this year, an annualised rate in the past six months of only 1%. The increase in cash terms was 3.5% in the past year, the lowest since the summer of 1967 before the devaluation in November of that year. Spending on the high street has slowed even more and in cash terms was up 0.3% in the year to May.
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Business investment has lost momentum. Having outpaced consumption in 2004 (5.5% versus 3.3%), it has risen only 0.1% in the past six months. Surveys of investment intentions are pointing to growth remaining sluggish at best. The June MPC minutes note that domestic final demand has risen less than the 0.6% that is required for trend growth in each of the last two quarters, the first time this has happened in 10 years.
Finally, on inflation itself, the MPC’s statement could say that although consumer price index (CPI) inflation has risen towards the 2% target, this is the result of temporary factors that are expected to unwind in the coming months and that overall pay growth has been muted so far this year.
CPI inflation has been 1.9% for the past three months, within a whisker of the 2% target, but some way above the 2004 average of 1.3%. A considerable part of the increase can be explained by the high oil price. This took petrol-price inflation to a peak of more than 10% and is behind the near-12% rise in household utility bills.
The ONS measure of core inflation, which excludes food, drink and tobacco as well as energy and which provides a better measure of underlying inflation pressure, is lower at 1.6% (see chart on right). In the coming months inflation may temporarily move above the 2% target but, with core inflation more subdued, it is unlikely to stay there for long.
The possibility of a tight labour market pushing up wages was one of King’s possible upside surprises. The current data do not bear this out, with headline earnings up 4.6% in April and underlying earnings, excluding bonuses, rising at a more sluggish 4.1%. Other labour-market indicators — such as unemployment and hours worked — are pointing to some easing of labour-market pressures, which reduces the chance of an upside surprise on earnings.
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It is therefore not difficult to rehearse the sort of statement the MPC might issue when it does cut rates. The version I have set out here is, with only minor modifications, the one that the MPC itself issued the last time it cut rates in July 2003 — when inflation as measured by the retail prices index excluding mortgage interest payments (RPIX) was above its 2.5% target.
Since current circumstances seem to mirror those of two years ago, when rates were cut from 3.75% to 3.5%, why are rates at a much higher level and why have they not been cut already? Why is King apparently trying to talk the financial markets out of the notion that an early move is on the cards? The one thing that has obviously changed since July 2003 is that the economy has less spare capacity — in the jargon, the output gap has closed. Two years ago the MPC could set rates to deliver above-trend growth; today it has to aim at no more than trend. Yet the data tell us that, by a narrow margin, we are not achieving trend and that inflationary pressures are beginning to diminish. Charlie Bean, with his finger on the pulse of the Bank’s model, can see that already. It is only a matter of time before his colleagues come round to that view and vote for a cut in interest rates.