Balloons have a habit of bursting

Posted on Posted in Bank of England, Inflation

While all eyes are on Mark Carney following the announcement that he is to stay on as Governor of the Bank of England until 2019, I wrote in August about the Bank’s decision to reduce interest rates from 0.5% to 0.25%.

I felt it was hasty and it is likely to see a quicker rebound than might otherwise have been the case. The Bank clearly got a bit wobbly about Brexit.

Evidence from our own clients points to a collective intake of breath in July and a cautious first six weeks post the vote. In fact, our SME Confidence Tracker showed business confidence at its lowest reading since 2014 in Q3.

Since then it seems that the previous equilibrium has been largely restored and official figures show that the UK economy expanded by 0.5% in the three months following the vote. Though a far cry from the frequent c4% growth of the 1990s, such growth surpassed expectations and led the ONS to suggest “there is little evidence of a pronounced effect in the immediate aftermath”.

So, was this due to heroic good judgement on the part of the Bank of England or did it have as much to do with a record British medal haul at the Olympics? My money is on the latter. The media refrained from shouting “recession” and day-after-day good things happened in Rio. The Union Jack rose and the anthem played.

While we await official figures, early indicators such as the Markit/CIPS Manufacturing PMI, point to a further rebound in confidence throughout October.

Meanwhile, the rate cut sent sterling spiraling down, reaching a new 31-year low against the dollar. Not just the rate cut, of course, the small matter of EU exit uncertainty also played a part, most notably so when Theresa May announced the timing of Article 50’s deployment in October.

Importing inflation

But with falling sterling, why cut rates?  To stave-off a downturn I suppose, but now we can clearly see the consequences. At the end of October, Microsoft announced a 22% price rise. Apple too have weighed in with a chunky uplift. This is likely just the start.

In August, data from HM Revenue & Customs once again highlighted the UK’s net-importer status, with imports exceeding exports by £18bn. Inflation has to rise as we import so much. The National Institute of Economic and Social Research (NIESR) has warned that it could rise to as much as 4% in the second half of 2017.

Exports can be boosted but it takes time to crank the production handle. By such time, it’s likely that input prices will have hardened and so the export drive may evaporate.

It’s at this stage that interest rates will simply have to rise and, due to August’s cut, the rebound is likely to be sharper than would have been otherwise necessary.

When rates do rise, I wonder what might happen to consumer confidence and consequently the orgy of new building currently devouring green fields across the South and Midlands.  What will happen to an already subdued mortgage market and the flotilla of lenders who have inflated an SME credit bubble?

An inflationary balloon is starting to strain and become more translucent by the day. Sometimes balloons deflate quietly in the corner. Sometimes they burst. Time will tell.

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