• Today’s decision by the Monetary Policy Committee to leave interest rates unchanged after last month’s reduction to 4.5% should not be interpreted as a sign that rates are not going to fall again. I think there are three reasons why interest rates are likely to be cut again.
  • First, it is very rare for interest rates to be moved only once in any one direction. Indeed, the last time this happened was back in 1988, when rates were raised in February only to fall in March. Policymakers are much more comfortable moving interest rates in a series of steps.
  • Second, the Bank of England’s own macro-economic model suggests that each 1% change in interest rates only alters GDP growth by about 0.3 percentage points in two years’ time. So last month’s 0.25% rate cut will do little to offset the consumer slowdown.
  • Third, the economic data have remained weak. The latest news on the high street suggests that the consumer slowdown has become entrenched. The reported sales balance of the CBI’s Distributive Trades Survey remained close to a 22 year low in August while the like-for-like annual growth rate of the BRC’s Retail Sales Monitor remained in negative territory for the fifth consecutive month. What’s more, Dixons – the high street stalwart – said its recent poor trading update was due to tough trading conditions.
  • Consumer spending is being put under further pressure by a softening labour market. The claimant count measure of unemployment rose for the sixth consecutive month in July and this week’s job cuts announcement by B&Q suggests that higher unemployment may persist.
  • Admittedly, the rise in inflation to 2.3% in July – above the MPC’s 2% target – is the largest obstacle to lower interest rates. And the upward impact of Hurricane Katrina on petrol prices will only push inflation higher in the near-term.
  • But as below target inflation did not stop the MPC from raising interest rates five times in 2003/04, above target inflation should not preclude more rate cuts. In any case, inflation is unlikely to stay high for too long as retailers will be reluctant to raise prices if demand remains weak. Accordingly, I reckon that rates will be cut by 0.25% in November and will fall to 3.5% next year.

Roger Bootle
Economic Adviser
Deloitte

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