Bank of England Preview: Interest Rate to Stay Unchanged

July 8, 2008

A two-day meeting of the Monetary Policy Committee (MPC) starts tomorrow and will culminate with no change to the 5.0% Bank Rate when the decision is announced on Thursday at 11:00 GMT.  Three cuts were made of 25 basis points each last December, February and April, and the most dovish member of the MPC, Blanchflower, is sure to dissent at this meeting in favor of a fourth rate reduction now.  The long-held prediction of this labor market economist that wages would stay subdued continues to be an accurate forecast.  His vote will not be known for sure until July 23rd when minutes will be released.  Britain’s June PMI’s were awful.  Manufacturing fell to 45.8 from 49.5 in May and 55.1 at mid-2007.  Services dropped to 47.1 from 49.8 in May and 57.7 in June 2007.  There sum of 92.9 was down 6.4 points from May and roughly 20 points from a year earlier.  Sub-50 readings in these diffusion indices represent contracting trends, and June saw the lowest scores since 2H01, meaning that slowdowns are quickening in pace.  The construction-sector PMI slumped to 38.8 from 43.9 in May, and consumer confidence of -34 hit its weakest point since at least 1986, which was before the last recession.  A surprising 3.5% jump in retail sales in May is a red herring.  Economic growth of 1.1% at a seasonally adjusted annual rate in 1Q08 was as good as it’s going to get for any quarter in 2008, and the only question left is whether a recession can be avoided.  I suspect not.  The U.K. economy was simply too dependent on financial services and had too little cushion for a fiscal stimulation to absorb the global credit crunch and soaring commodity prices.

Few economies face a more acute stagflationary risk than Britain, however, which is why the Bank of England cannot charge ahead with rate cuts.  CPI inflation is at 3.3% and heading quite a bit higher.  Britain has a legacy of spikes in CPI inflation.  In 1990 after Iraq invaded Kuwait, CPI inflation peaked at 3.3% in Germany, 3.9% in France, 6.3% in the United States, 6.5% in Italy but 10.9% in Britain.  PPI inflation is presently at 8.9%, and expected inflation according to a Bank of England quarterly survey accelerated a full percentage point from 3.3% in February to 4.3% in May, the highest since at least 1999.  This is no time for gambling on a rate reduction.  Whereas Blanchflower is the MPC member with the sharpest predisposition for lower rates, Besley and Sentance comprise the hawkish end of the committee’s ideological spectrum.  It would be hugely provocative if they dissent in favor of a rate hike as they did in April but not May or June. I do not expect a dissent from them this week given the state of the outlook for growth, but I would not bet everything on that view. One consideration is sterling, which is within 15% of its all-time low against the synthetic Deutschemark, 28% weaker than its post-EMU launch high and down 15% in the past 12 months.



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