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Economic Update – Rates must stay low to get recovery going again

Roger Bootle’s response to May's MPC meeting


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  • Just a few weeks ago it was considered a done deal that the MPC would hike rates this month, so today’s no-change decision shows just how easily the mood can change. Most forecasters now think that the tightening cycle will simply start later this year instead, but I am sticking with my view that interest rates will stay at 1% or below until 2014.
  • Just because the Committee held fire today does not mean that the risk of a near-term interest rate rise has disappeared. March’s fall in inflation was reassuring – but is likely to be only a temporary reprieve.
  • With oil prices still at close to $120 per barrel, CPI inflation looks likely to start rising again and could yet reach the 5% of which the MPC has already forewarned. Accordingly, those Committee members worried about the damage this is doing to the MPC’s credibility will not be able to rest easy for a while yet.
  • However, the second-round effects that the Committee has been so fearful of have still not materialised. Households’ inflation expectations over the next year actually fell on the YouGov/Citigroup measure in April. And pay growth has barely picked up. This morning’s figures from Incomes Data Services showed that the median pay settlement was 2.5% in March, unchanged from its level in the previous two months and suggesting that the initial panic about the rise in settlements at the start of the year was overdone.
  • What’s more, the news that underlying activity has been flat for the last six months suggests that the economic recovery has petered out altogether. And that’s before the fiscal squeeze has been fully felt. Households are probably only just starting to adjust to the rise in taxes and cuts in benefits brought in since the start of the year, while the bulk of the government spending cuts are yet to come.
  • Even the manufacturing recovery – the bright spot of the recovery in the past few months – has come off the boil. I think that the economy will struggle to achieve even my relatively bearish forecast for growth this year of 1.5%. 1% - or even lower – looks quite possible.
  • Given this, the MPC would be foolish to raise interest rates and kill off any chances of the recovery regaining momentum. After all, if the economy continues to struggle like this, next year the threat of deflation will start to rear its head again and people will start to ask how the MPC can provide more support to the economy. And the ECB – which raised euro-zone interest rates last month – has been widely criticised for raising rates prematurely.
  • I therefore still think that a rate hike this year will be avoided. And at the start of next year, when the VAT rise drops out of the annual inflation rate and both inflation and inflation expectations drop back, the hawkish case will be even weaker. Even though interest rate expectations have fallen sharply in the past few weeks, markets are still failing to grasp that – whether rates rise this year or not – we are not about to see a sustained policy tightening.

Roger Bootle, Economic Adviser to Deloitte (Tel: 020 7823 5000)

This assessment contains general information only and is not intended to be comprehensive nor to provide professional advice.  It is not a substitute for such professional advice and should not be acted on or relied upon or used as a basis for any decision or action that may affect you or your business.  Deloitte LLP accepts no duty of care or liability for any loss occasioned to any person acting or refraining from acting as a result of any material in this assessment.

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