Contact: Jo Ouvry
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Today’s 0.25% cut in interest rates to 4.5% – in line with my long-standing forecast and the first cut since July 2003 – will not be enough to offset the economic weakness caused by the housing market and consumer spending slowdowns. More cuts will be needed.
This is not to say that the Bank has made a major mistake. On the contrary, it has managed the containment of inflationary pressures and the gentle deflation of the housing market brilliantly.
If it has made even a minor error it has been to underestimate the effect of the slowing housing market on consumer demand, causing it to be a little slow to reduce interest rates. Still, history indicates that when the MPC moves it does so quickly, and it can soon make up for lost time.
It is possible that the Bank will use next week’s Inflation Report to signal that another cut could come soon. Indeed, this is a strategy that the Committee adopted in May last year when interest rates were on the up.
The MPC now faces a new challenge in judging how far and how fast rates should fall. The difficulty will be balancing the need to moderate the consumer slowdown against a potential inflationary threat from a lower pound. But it should attach little weight to the latter. While consumer demand is soft and unemployment rising, that inflationary threat will not materialise. And allowing the pound to fall a good way will help to achieve something the Bank has long wanted – a rebalancing of the economy towards the traded sector.
It should not be deterred by the danger of re-igniting the housing market. Reductions in rates will not cause house price inflation to re-accelerate, because excessively high interest rates were not the problem in the first place. The problem is that house prices are too high in relation to earnings. This means that investors face unfavourable prospects for immediate capital gains while first time buyers face difficulty in amassing the necessary deposit. Lower interest rates will make little difference to these two problems.
Nor should the Bank be worried that UK rates are falling while rates elsewhere in the world are steady or rising. UK rates have been at much higher levels and the cycle here has been out of phase, partly as a result of the MPC’s success in stimulating consumer demand and the housing market to offset the weakness of the external sector.
Financial market participants should note that the secular downtrend in UK interest rates is still in place. Rates have peaked in this cycle at 4 ¾ %, compared to 6 % in the previous cycle. I think that rates will be at 4% by Christmas and that they will fall all the way to 3.5% by the middle of next year. But given that 3.5 % was the trough of the last cycle, when the housing market and consumer spending were strong, it is perfectly plausible that rates will need to go even lower.
Ends
Notes to 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 020 7823 5000 or via email on business@capitaleconomics.com.
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