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The Monthly Banker: 16 November 2006
Bank of England MPC minutes highlight inflationary fears........................
    

10th November, 2006

If August’s rate hike came as a shock to most of us, yesterday’s move by the Bank of England was anything but.
 
Since then the Bank has done little to dampen expectations of further rate increases and speculation mounted further last month when two dissenters voted for a hike.  The only real surprise on that occasion was that it was left to the new boys, Tim Besley and Andrew Sentance, to vote for a hike, rather than any of their supposedly more hawkish, senior colleagues.
 
Thus the market had decided well before this week’s meeting that a hike was all but inevitable and was not dissuaded by Governor King’s protestation that “nothing had been decided”.
 
So what has changed since MPC members convened for August’s fateful meeting?  You could reasonably argue that with oil prices falling and the US economy palpably slowing (though still far from recession) the Committee might have concluded that no further action was required of it.
 
What does seem to have happened is that the Band of Brothers (and sisters) has grown more certain about its fears and less willing to tolerate deviations from its inflation target.
 
Back in June there was much amusement when Mervyn King said in his annual Mansion House speech that the Bank wouldn’t be giving investors any indication as to the future path of UK interest rates “for the simple reason that we don’t know and it would be quite misleading to pretend otherwise".
 
Contrast this with yesterday’s brief post meeting statement, which informed us that although “oil prices have dropped back…there are signs that other pricing pressures have picked up.”  Worse still the statement added that “it is likely that inflation will rise further above the target in the near term”.
 
Two hikes later and nobody is finding Mr King quite so funny.
 
The basic problem is that inflation has been a little too high for a little too long.  Inflation may be only a pale shadow of its former self, but reports of its demise are somewhat exaggerated.  Indeed the beast seems to be taunting us, by repeatedly stepping slightly over the line in the sand that the authorities have drawn for it.
 
A more decisive acceleration in prices would have drawn a swift and predictable response from policymakers.  These small incursions, however, bring with them the hope that the blip will prove temporary and that order can be restored without resorting to deliberately pushing unemployment higher.  This hope is all the more earnest as unemployment seems to be managing to rise even as pressures elsewhere are causing inflation to quicken.
 
What has decisively tipped the balance is the resurgence of the property market.  As we have commented before, this is somewhat inconvenient for the Bank.  Central bankers in general are loath to be dictated to by asset prices.  The Bank of England itself has a history of being sceptical of real estate’s impact on consumer demand, most notably former MPC member Stephen Nickell.  Even the current Deputy Governor Rachel Lomax is an alleged sympathiser.
 
However, it is equally true that no central banker can stand idly by as the prices of the most expensive and prestigious houses in the land accelerate at a rate close to 25% per annum.  All the more so since it was last year’s ill-advised interest rate cut that appeared to be the spark that reignited the market.
 
 
 
Figure 1 (data Knight Frank Residential)
 
So the key question is, where to from here?  Again doves could make a case for restraint by highlighting the record level of personal bankruptcies and the mania for so-called Individual Voluntary Arrangements (IVAs), which have more than doubled over the past twelve months.
 
These personal tragedies, however, are more a function of the vulnerable being aggressively marketed to by the unregulated than any sort of reliable read on the economy.  If anything the numbers highlight the apparently growing rift between the property “haves” and “have nots”.
 
The burden of unsecured borrowing, combined with tighter standards at the banks, has caused consumer lending to slow dramatically.  Mortgage approvals though are a different story entirely, climbing to two-year highs in October and apparently set to accelerate further as lenders compete to lend ever larger multiples for ever longer terms.
 
The problem with using monetary policy to manage inflation is that the relationship between rates and prices is non linear, at least in the short term.  The transmission mechanism for interest rates to affect prices is pain, economic pain.  Just because large interest rate hikes have slain mighty inflation dragons in the past, it does not necessarily follow that baby versions can be seen off with a good tickling.
 
If you make a minor change in monetary policy, by and large you will have to wait up to two years to see whether that change has had the desired affect.  If you just tinker with the controls, you can’t really expect to have much impact on the direction of prices in the short term. 
 
Now inflation might just turn lower of its own accord, which is certainly what the Bank is hoping.  The problem will come if prices remain a little too high, for a little too much longer, a scenario which isn’t too tough to imagine while City financiers and foreign tax exiles continue to bid up the prices of property in the choicest parts of London.
 
If that does remain the case, at least we now all know better than to be taken by surprise again.
 
Incidentally the Fed is in a remarkably similar situation.  With inflation still unacceptably high on a medium term view, investors are nevertheless betting on when rates will be cut.  FOMC members are certainly hopeful that inflation has peaked and have said as much.  However, those same officials are now increasingly warning that if the rise in prices doesn’t slow as expected, further action will need to be taken.
 
END