Faced with uncertain outlook, rate setters slip into neutral

Mervyn King once likened the process of setting interest rates in the UK to driving a car with the windscreen blacked out. Policy makers had to judge where they were going by looking out of the rear window to see where they had been.
The delicacy of this manoeuvre means there are times when the Bank needs to slip into neutral and coast along for a bit. Yesterday it used the minutes of the monetary policy committee meeting earlier this month which voted 9-0 to keep rates at 5.75% to suggest that it had done just that."There was range of views about the risks to inflation and growth. The future path of Bank Rate would depend on the evidence in the months ahead about whether and how the risks were crystallising; most members emphasised that they had no firm views on whether rates would need to rise further," the Bank's minutes said.
Stripped down to basics, that remark means one thing: City speculation that the Bank will underline its get-tough approach to inflation with a sixth rise in the Bank rate in little more than a year when it meets next month is for the birds. If rates are to go to 6%, it will not be until later in the year and there is a good chance that 5.75% will be the peak.
Certainly, that is the growing sentiment in the financial markets. Sterling has slipped below $2 and looks vulnerable to further falls. In the money markets, three-month interbank rates have fallen below 6% for the first time in four months - a marked change of mood from a month ago when the talk was of borrowing costs going to 6.25% by the end of 2007 and staying there for the whole of 2008.
There are three main reasons why the Bank is now in wait-and-see mode. Firstly, recent economic data hardly suggests that further increases in the cost of borrowing are needed to curb inflation. The July consumer prices index showed the cost of living up 1.9% on a year earlier, below the government's 2% target and a far cry from the 3.1% in March that forced Mr King to write an explanatory letter to the then chancellor, Gordon Brown.
Weather
One of the MPC's hawks, Andrew Sentance, yesterday used a regional newspaper interview to warn against reading too much into one month's inflation data, and some analysts believe that there were one-off factors, such as the wet weather, which artificially suppressed inflation last month.
There is, however, evidence that consumer spending is slowing. The Royal Institution of Chartered Surveyors earlier this week reported a big drop in housebuyer inquiries, while the supermarket price war has been prompted by weaker demand.
Government figures released yesterday showed that inflationary pressure from the labour market remains minimal. Despite a fall in the claimant count unemployment rate to 2.6%, the growth in average earnings fell to a four-year low of 3.3%. Real disposable incomes fell in both the final quarter of 2006 and the first quarter of 2007, making it more difficult for consumers to maintain their spending habits.
The second factor - linked to the first - is the vulnerability of the UK to the global financial markets. In the year to June, output grew by 3%; of that, 1.3 percentage points came from financial and business services.
Stephen Lewis, an economist at Insinger de Beaufort, said: "The UK economy could take a hard knock from latest developments in global markets."
He added that of all the major central banks, the Bank of England had most reason to fear the macro-economic fall-out from the market turmoil, given the UK's dependence on financial services activity for GDP growth.
"There have been no horror stories yet from UK financial institutions relating to their exposure to the US mortgage mess. However, UK banks and financial advisers are liable to suffer indirectly, through a diminution in the flow of corporate deals. Such transactions have relied on investors' voracious appetite for risk. Now that appetite has turned to aversion, this type of financial activity will be scaled back."
Nick Parsons, head of market strategy at NAB Capital, said a financial market slowdown would affect not just dealers and analysts but ripple out to all the ancillary services that rely on the spending power of the City.
"Bonuses in E14 [the London district that contains the financial centre of Canary Wharf] had a big impact not just on London but on the growth of the whole UK economy. Take away those bonuses and you will have the same multiplier process, only in reverse."
Graham Turner, of GFC Economics, said: "London is incredibly vulnerable to a severe downturn in global financial markets. It has been the centre of the proliferation in credit derivatives products and the investment banking community has been a main driver of the UK economy.
"Had we not had the strength of the financial sector, average earnings growth across the economy would be below 3%."
Turmoil
With many analysts believing the market turmoil is likely to intensify over the coming months, a final factor is that the hawks on the Bank's monetary policy committee will find it harder to secure the votes necessary to raise rates. At present, the committee is divided into three distinct camps - those who think rates need to go to 6% at some point, those who think they do not, and the swing voters in the middle whose view will be decisive.
This latter camp includes the Bank's chief economist, Charles Bean, its financial markets director, Paul Tucker, and Kate Barker, one of the four outside experts. Bean, Tucker and Barker all voted against a rate rise in June before sanctioning tighter borrowing in July, and will need some convincing that the car is not going to stall if rates go to 6%.
Some analysts believe it is now or never for the hawks. "The longer the Bank waits", said Mr Parsons, "the harder it will be to raise rates."