Economic trends - Mixed messages from the Old Lady

Inflation expectations are highest among the swathe of factors to consider when analysing the future path of UK interest rates, says Danny Gabay.

Mervyn King, governor of the Bank of England, famously announced that his ambition is to make monetary policy 'boring', or at least predictable and transparent. However, UK monetary policy has been anything but boring or transparent recently. Twice in the past six months, the rate-setting committee that King chairs, known as the Monetary Policy Committee (MPC), has surprised the financial markets with its interest rate decisions.

Much of the surprise was centred on the timing of the rate moves rather than the decisions themselves. Financial markets had got used to thinking that interest rates would only change on a quarterly basis, to coincide with the Bank's inflation report. January's hike had everyone asking: 'What do they know that we don't?'. For most the answer came a week later with the news that the measure of inflation that the MPC is tasked by the government to keep as close as possible to 2%, had risen to 3%. The older RPI measure had risen to a 15-year high of 4.4%. One index point higher, and Mervyn King would have been forced to write an open letter to the chancellor explaining why inflation was so far away from its target, and what the committee intended to do about it. The MPC acknowledged that it had been given a confidential sighting of this number in advance of its decision.

To many in the market the decision became understandable. But to others, not least a significant minority of the MPC itself, the decision laid the committee open to the charge of over-reacting to one month's number - a serious charge for a central banker. We now know that the decision to raise rates in January was carried by the slimmest of margins, with the governor effectively using his casting vote to push the decision through by five votes to four. The minority will have felt a good deal of vindication when inflation fell back to 2.7% in January, exactly where it was in November.

All of this has significantly increased the uncertainty around the Bank of England's likely future policy moves. Or, in the jargon, its reaction function. Of the 50 or so market economists regularly surveyed, some now think interest rates will have reached 5.75% by the end of the year, while others think they could have fallen to 4.5%, and on average they expect them to end the year about where they are now at 5.25%. No wonder economists have a bad name.

The credibility of a central bank with an inflation target, like the Bank of England, can be measured by how close to that target economic agents expect future inflation to be. If workers think the MPC is now more tolerant of 3% inflation, it makes sense for them to bid for wage gains of at least that magnitude. The same goes for retailers. And higher inflation has an unpleasant habit of becoming a self-fulfilling prophecy, as wages chase inflation ever higher. Hence the MPC is watching the current wage round with a very keen eye.

Good news

The good news is that inflation should carry on falling from here, perhaps sharply. Oil prices have fallen sharply in recent months and consumers should soon start to feel the benefit of lower energy bills. It is worth noting that UK consumers seem uniquely disadvantaged when it comes to energy bills with respect to their European cousins. For example, retail gas prices have risen by over 80% in the UK since 2003, compared with just 30% in Europe. If these lower costs are passed on fully, lower energy bills could bring UK inflation back below 2% by the summer.

The message from the MPC is that one more interest rate hike should be enough. Even so, at 5.5%, UK interest rates will be at their highest level since 2001, or since before the latest housing market bubble got going.

Few commentators are still brave enough to predict the future path of house prices. But the housing market could well be the elephant in the room as far as the UK economy is concerned. The combination of falling inflation and higher nominal interest rates could yet spell danger for the UK's overstretched housing market.

Danny Gabay is director of Fathom Financial Consulting, and was previously UK economist for JP Morgan Chase and the Bank of

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