Investment Management Blog - Montague Capital

We only have a few hours to wait for the first official reasons, contained within the Quarterly Inflation Report, for why the Monetary Policy Committee did not raise rates in front of yesterday’s horrible inflation numbers.  CPI rose from 3.8% to 4.4% and RPI from 4.6% to 5.0%.  The official CIP target is supposed to be 2%, yet the market is talking already about 5% next month.

The most likely explanation is that the QIR will describe a new deterioration in growth prospects to accompany the awful inflation picture.  This would give the MPC more confidence that economic slowdown should eventually be enough to bring inflationary pressures under control, because companies struggling to stay in business will find it hard to pass on price increases and will not be in a position to afford inflation-busting wage increases.  July unemployment data, also due out later today, will show how far that proposition hold true.

However, that reasoning looks questionable for two reasons.  Firstly, the MPC itself has always warned of the asymmetry that results from leaving inflation unchecked for too long.  Failure to act promptly only leads later to much tighter policy than needed to be the case, making any recession far deeper.  Secondly, the MPC has also talked sternly in recent months about the need to contain inflationary expectations.  How have they been contained when the consensus for August’s number is already 5%?

Admittedly there have been very sharp changes recently in the prices of some components in the overall inflation basket.  The oil price fell about 11% over July (and more this month to date) and returned roughly to the level that prevailing at the end of May.  Retailers are now finally starting to pass this fall on in the shape of lower pump prices, which will bring some respite from the crushing trend of increases seen over the last year.  But utility bills have seen huge price rises this month that will negate any benefit from lower fuel costs, with similar rises threatened for January.  There is optimistic talk that basic food prices are falling, but we’re not yet eating bread made from this year’s wheat harvest and bakers don’t price on a “last-in first-out” basis.  The proof of that particular pudding will be in the eating.

When we see the minutes of last month’s rate-setting meeting we will know, without any possibility of doubt, how the MPC decided to interpret yesterday’s inflation number in the context of the QIR’s forecast of long-term trends.  It is very, very hard to see how votes in favour of a cut will have gone up, unless those who join the Blanchflower camp want to achieve a similar lack of credibility.  With numbers like these, saying that inflation is under control has about as much plausibility as arguing that Gordon Brown will win the next general election.  Rather, how many new “hawks” will there be?

One new slant comes to mind however.  As consumers we are told that we notice most the price increases of items we buy frequently and which we might pay for in cash, like food and fuel.  (Although filling up with fuel these days usually requires one to present the deeds of one’s house as collateral to protect the petrol station against default on the credit card.)  Put a different way, we listen most to what we heard last.  Understanding and submitting to any change in policy is easier if the groundwork has been done first – “Interest rates are going up because…..”.  But the timing of that change is also important.  If the wage negotiation cycle has a peak, it is roughly at the calendar year end.  By October, when world harvests are in and we have a better idea of whether the trend in the oil price over the last three weeks has been sustained, there will be greater confidence in the validity of forecasts for inflation and growth.  But, and this is the important bit, any rise in rates which may by then have proved necessary will be a fresh memory in wage negotiators’ minds on both sides of the table.  Employers will know with painful clarity what they can afford.  Unions won’t be trying to demand compensation for a July rate rise as a cost-of-living increase when the price of victory is fewer jobs.

Sadly, this story has a nasty sting in the tail.  Economic theory tells us that countries with an inflation problem experience a deteriorating exchange rate, because of poor relative purchasing power and inadequate real rates of interest (especially when monetary policy is visibly too weak).  This is happening to Sterling now.  Yesterday it hit a six-month low against the Euro and a two-year low against the dollar.  What do we need in this country to pay for oil?  Or cars?  Or TVs?  Or…..