• I think that the continued problems in the financial markets and the associated tightening of credit conditions will mean that today’s 0.25% cut in interest rates to 5% is another step towards rates eventually falling to 3.5%. 
• Admittedly, the backward-looking news on activity has been fairly good. The Q4 National Accounts showed that although GDP growth is slowing, it is not collapsing. Moreover, the manufacturing sector appears to have enjoyed a surge in activity, while the official retail sales figures suggest that consumers have continued to spend on the high street. And the 166,000 rise in employment in the three months to January suggests that the labour market is in rude health.
• However, the flood of evidence that mortgage lenders are withdrawing products and raising rates suggests that the 2.5% monthly fall in house prices in March reported by the Halifax could be the tip of the iceberg. Interestingly, the MPC did not refer to the housing market at all in the statement released alongside its decision, presumably for fear of being accused of targeting asset prices or undermining confidence further.
• Nonetheless, it is becoming increasingly likely that house prices will fall both this year and next. And if the housing market continues to slow at anything like current rates, it is surely only a matter of time before consumers decide to batten down the hatches. Moreover, the more forward-looking surveys have started to reveal some cracks in the labour market. The danger is a vicious circle of falling employment, lower house prices and weaker consumer spending.
• Indeed, even after today’s cut, official interest rates are probably still at a level that is acting as a brake on economic activity. Due to the problems in the financial markets that have pushed three month interest rates up to just under 6%, overall monetary conditions are probably no looser than they were last summer when official interest rates were 5.75%.
• Of course, the MPC has not abandoned its inflation concerns altogether. Indeed, the statement said that “above-target inflation this year could raise inflation expectations so that…inflation would remain above the target”. This is not too surprising given that the Bank’s own measure of the public’s inflation expectations has already risen to a record high of 3.3% in February and that the YouGov/Citigroup measure hit 3.6% in March.
• But it is clear that the downside risks to the inflation outlook stemming from a prolonged period of very weak activity are growing relative to the upside risks from cutting interest rates further. The upshot is that interest rates need to come down considerably further. I expect that rates will fall to 4% by the end of this year and further to 3.5% in 2009. And even this won’t be enough to stop GDP growth from slowing to just 1% or so next year.

Ends

Notes for editors
This press release has been prepared by Roger Bootle, Economic Adviser to Deloitte.  If you have any questions regarding the views in it, please contact Roger Bootle directly on 07887 955 875 or 020 7823 5000 or via email on business@capitaleconomics.com.

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