Analysts are expecting interest rates in the UK to peak at six per cent in the present cycle, following the recent hike to 5.75 per cent. This should happen by September. Broadly speaking this is not because of a change in the economic outlook. This has only marginally been revised upwards for the year to 2.7 per cent. However, it is still expected that inflation will end this year below target and to remain there through 2008.
What really matters is how the Monetary Policy Committee (MPC) of the Bank of England (BoE) views the outlook and, increasingly importantly, how it views the risks. The Governor of the BoE has always said he believes monetary policy should be boring. However, this year has been far from that. The rise in inflation over the turn of the year, the first time the independent BoE has really seen a substantial increase in inflation above target, has had a marked effect on its sentiment.
The Bank of England feels it has lost credibility in maintaining low inflation, which now needs to be won back. This was stated explicitly in the recent Inflation Report. It was clear that the MPC's latest economic projections were based on the assumption that inflation expectations take some time to return to the target. It is also becoming increasingly apparent in the MPC's other behaviour: The reaction to recent inflation outturns at the turn of the year; the unanimous vote for the hike last May; and the Governor's hard line message in recent speeches.
To regain credibility the MPC needs to see something dramatic like a marked slowdown in activity. The latest minutes described the view that, "a slowing of demand growth to below potential was probably necessary if inflation was to hit target in the medium term." In short, there is the expectation to see a clear and significant weakening in domestic demand until the end of the current quarter, when consumer spending is expected to weaken more aggressively.
For so long as the reaction from consumers to previous increases in interest rates can be described as 'tentative', and firms' pricing expectations remain elevated, a majority on the MPC will fear that their credibility is not being restored and that they will need to keep raising interest rates.
Moreover, the pricing intentions in the business surveys - which they have highlighted as key - will remain fairly elevated over the next few months. That is partly because much of the slowdown in consumer demand is yet to come. However, it is also because oil prices continue to edge up and there is the belief that energy prices are the main driver behind these pricing balances rather than excess nominal demand.
Therefore, MPC's uncertainty over the inflation outlook will persist for some months. In the face of that uncertainty, the Committee is not risking a "wait and see" approach.
The timing of future interest hikes is obviously difficult as the committee is so divided and the outcome of each meeting essentially depends on the current thoughts of the marginal voter. So each month will continue to be a close call. In the absence of any plunge in early indicators of third quarter consumer spending, September is most likely.
Risks to a six per cent peak - upside
Consumer demand fails to slow in any significant way.
Higher interest rates encourage capital inflows, boosting money and credit lending.
Inflation expectations remain persistently elevated.
Earnings growth starts to accelerate.
Risks to a six per cent peak - downside
A sudden, sharp reaction on consumer spending to past interest rate hikes, perhaps as households come off lower fixed rate mortgages through the summer "Inflated asset prices" fall back with negative wealth effects.
US subprime weakness does filter out to the broader economy with possible implications for export demand.
The high level of the sterling starts to have a large effect on trade.
Employment weakens further
It would be wrong to expect interest rate cuts too early. Inflation is seen as being below target through next year and growth below trend, an environment in which the market is likely to look for the BoE to provide some stimulus. However, it is believed this will actually be a backdrop the BoE will be happy to sit with, to ensure inflation expectations become firmly re-anchored. If inflation should remain more persistent, as seen in the US, the BoE's hand will be tied, regardless of how weak activity becomes.
• This report was compiled by Peter Calleya, manager corporate strategy and research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.
What really matters is how the Monetary Policy Committee (MPC) of the Bank of England (BoE) views the outlook and, increasingly importantly, how it views the risks. The Governor of the BoE has always said he believes monetary policy should be boring. However, this year has been far from that. The rise in inflation over the turn of the year, the first time the independent BoE has really seen a substantial increase in inflation above target, has had a marked effect on its sentiment.
The Bank of England feels it has lost credibility in maintaining low inflation, which now needs to be won back. This was stated explicitly in the recent Inflation Report. It was clear that the MPC's latest economic projections were based on the assumption that inflation expectations take some time to return to the target. It is also becoming increasingly apparent in the MPC's other behaviour: The reaction to recent inflation outturns at the turn of the year; the unanimous vote for the hike last May; and the Governor's hard line message in recent speeches.
To regain credibility the MPC needs to see something dramatic like a marked slowdown in activity. The latest minutes described the view that, "a slowing of demand growth to below potential was probably necessary if inflation was to hit target in the medium term." In short, there is the expectation to see a clear and significant weakening in domestic demand until the end of the current quarter, when consumer spending is expected to weaken more aggressively.
For so long as the reaction from consumers to previous increases in interest rates can be described as 'tentative', and firms' pricing expectations remain elevated, a majority on the MPC will fear that their credibility is not being restored and that they will need to keep raising interest rates.
Moreover, the pricing intentions in the business surveys - which they have highlighted as key - will remain fairly elevated over the next few months. That is partly because much of the slowdown in consumer demand is yet to come. However, it is also because oil prices continue to edge up and there is the belief that energy prices are the main driver behind these pricing balances rather than excess nominal demand.
Therefore, MPC's uncertainty over the inflation outlook will persist for some months. In the face of that uncertainty, the Committee is not risking a "wait and see" approach.
The timing of future interest hikes is obviously difficult as the committee is so divided and the outcome of each meeting essentially depends on the current thoughts of the marginal voter. So each month will continue to be a close call. In the absence of any plunge in early indicators of third quarter consumer spending, September is most likely.
Risks to a six per cent peak - upside
Consumer demand fails to slow in any significant way.
Higher interest rates encourage capital inflows, boosting money and credit lending.
Inflation expectations remain persistently elevated.
Earnings growth starts to accelerate.
Risks to a six per cent peak - downside
A sudden, sharp reaction on consumer spending to past interest rate hikes, perhaps as households come off lower fixed rate mortgages through the summer "Inflated asset prices" fall back with negative wealth effects.
US subprime weakness does filter out to the broader economy with possible implications for export demand.
The high level of the sterling starts to have a large effect on trade.
Employment weakens further
It would be wrong to expect interest rate cuts too early. Inflation is seen as being below target through next year and growth below trend, an environment in which the market is likely to look for the BoE to provide some stimulus. However, it is believed this will actually be a backdrop the BoE will be happy to sit with, to ensure inflation expectations become firmly re-anchored. If inflation should remain more persistent, as seen in the US, the BoE's hand will be tied, regardless of how weak activity becomes.
• This report was compiled by Peter Calleya, manager corporate strategy and research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.