Memorandum submitted
by Mr Roger Bootle, Capital Economics
1. While the November Inflation Report was
unsurprisingly pretty dovish in tone, it stopped just short of
confirming that interest rates have now reached their peak.
2. As the Chart (on the next page) shows, on
the basis of current market expectations of a flat profile for
interest rates, CPI inflation is expected to rise to meet its
2% target over the next two years. But it is then expected to
rise a bit above its target in the third year of the forecast,
suggesting that, while the Committee sees no urgency to hike again,
it perhaps feels that another increase might eventually be necessary
to keep inflation on target in the medium-term.
3. With regard to the inflation outlook, I broadly
concur with the Bank's profile, although I think, not for the
first time, it is overdoing the inflation dangers. I suspect too
that the intense competitive pressures in the high street will
mean that CPI inflation does not rise quite as high as the MPC
predicts over the next two years, despite the recent build-up
of costs pressures further down the pipeline.
4. With regard to interest rates, I am not sure
whether they have peaked but if they have not then the peak is
very close. Moreover, it seems to me that the forces for lower
rates next year are gathering strength. In particular, if house
prices continue to slide, while inflation remains low, then the
Bank will surely switch to be concerned to prevent a period of
serious weakness in the housing market, possibly accompanied by
weak consumer spending as well. I expect rates to fall to 4.5%
by end 2005 and to 4% in 2006.
5. But if this view becomes widely established
it makes it more likely that the housing market could rebound,
thereby complicating the Bank's task still further. Accordingly,
it should not be surprising that the Bank does not want to encourage
this message.
6. It was very striking that the Bank stated
that it now expected house prices to fall modestly next year.
While this appears relatively anodyne it was a marked departure
from previous statements and was potentiality highly significant.
I suspect that the Bank wants to do what it can to make sure that
the market does not rebound—particularly if rates are not
going to rise again, and may even fall before too long. If you
like, it is trying to use talk as an alternative to action. And
so far, the signs are that this tactic is working.
7. The Bank made a strong call in arguing that
the relationship between the housing market and household spending
has broken down and accordingly, that a period of falling house
prices would not lead to pronounced weakness in consumer spending.
As it happens, I think that the Bank is right about this. However,
I have argued that house prices will fall by 20%, and perhaps
by much more. This is clearly more than the Bank's "modest
falls". Accordingly, the effect on consumer spending and
on the economy would be larger. Moreover, there is a risk that
the relationship between the housing market and consumer spending
which appears to have broken down in the years of surging house
prices reasserts itself in the years of falling house prices.
In that event, the Bank's forecasts for GDP growth and inflation
would prove to be too high and the forces pushing for lower interest
interest rates would be correspondingly stronger.
17 November 2004
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