Tuesday, September 23, 2008

Interest Rate Forecasts for UK

The continuing financial crisis increases the chance of an interest rate cut in the UK.

Basically, the MPC are caught between two conflicting pressures. Their fundamental target is low inflation. CPI 2% +/-1. Using CPI, they are clearly above the target (at 4.4%). Using a more comprehensive measure of inflation - RPI, which includes housing costs and council tax, inflation is running even higher at 5.1%. Given these statistics, in normal times, the MPC, would be contemplating interest rate increases. However, these are not normal times. Given the impending prospect of a recession and rapidly rising unemployment, the inflation target of 2% somehow doesn't seem so vital.

There are several reasons to argue that interest rates could fall significantly over the next 12 months, possibly to as low as 3.5%
  • Inflation is forecast to peak soon and then drop back down. One important factor is the drop in oil prices. After reaching over $150 in early summer, the price of oil has fallen just as quickly (though with less coverage). At close to $100, we could see petrol prices and transport costs fall soon. This will make a significant improvement in inflation figures. Alone, this drop in oil prices could bring inflation back on target.
  • With falling economic growth, the outlook is for lower demand pull inflation. In recession, firms usually respond by cutting prices to attract customers.
  • There is evidence that the commodity price boom and food inflation is coming under control. This will also help reduce cost push inflation.
  • Unemployment is rising at its fastest level since 1992. The recent banking troubles, will only add to the unemployment figures and create a negative multiplier effect, especially around London.
  • Despite Central bank injections of money, the banking system is still short of liquidity. It is going to be difficult to borrow and finance mortgages. Lower interest rates, would help encourage consumer spending and give a little relief to the beleaguered housing market.
Given the raft of depressing news on growth and unemployment, the MPC, may decide to cut rates sooner rather than later. They will hope, that early rates will not cause inflation, but, will help mitigate the impact of an economic slowdown.

Problems of Cutting Interest Rates

Apart from inflation concerns, there are a couple of problems with cutting rates.
  1. Moral Hazard. The financial sector has created problems by borrowing too much. Cutting interest rates aggressively, may just encourage these poor lending practises to continue. Arguably, the interest rate cuts in 2001 in response to the dotcom bubble, encouraged another boom. There is a need for a readjustment, in particular there is a need to increase the deplorably low savings ratio.
  2. Interest rates may not have an effect. Textbook analysis suggests interest rate cuts will increase demand. But, it is possible interest rate cuts will fail to boost growth. If confidence is low, if house prices continue to tumble, lower rates may have very little effect in boosting spending. For a real example, one has to only look at the example of Japan, whose interest rates of 0% failed to avoid a period of deflation.

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