Economics - When a little goes a long way

When base rates went up to 3.75% at the Monetary Policy Committee’s November meeting, it brought to an end a 45-month period without a rate rise. The last time rates rose was in February 2000 and not since 1939-1951 has the UK gone so long without an increase in interest rates. For the 1.6 million first-time buyers who have taken out mortgages in the last three-and-a-half years, higher interest rates will be a new experience.

It was hardly a surprising decision. A close vote at the previous meeting and the first major speech as Governor by Mervyn King had signalled that some policy tightening was imminent. A cynic might claim the MPC had merely clawed back July’s ill-judged cut in rates to 3.5%. Back then, the Bank believed the housing market was cooling, consumer borrowing was slowing and high street spending was easing. Within two or three weeks, these arguments were refuted by official statistics. This so-called precautionary cut gave a boost to consumers who hardly needed any extra encouragement.

Significant revisions to the official data made it clear the economy was doing better in the first half of this year than was originally thought.

At the same time, surprisingly good figures from the US suggested that, Europe apart, a global recovery was finally underway. Adding all these elements together meant a rate rise in November was easier to predict than Peter Reid’s sacking by Leeds United a few days later.

Inflation rather than growth appears to be the major priority. When the world economy started to weaken in 2001, the MPC was concerned to ensure that activity in the UK was maintained and more jobs were created. The response then was to cut rates by a third. Now, at a time when there is little spare capacity, increasing demand runs the risk of the UK overshooting its inflation target. Rates have been raised to reduce inflationary pressures.

Nobody believes that a rise of one quarter of 1% is going to lead to a collapse of the housing market, send retail sales growth into reverse, stifle investment and choke off the nascent recovery. The real concern is whether this increase is merely a precautionary tap on the brakes or a prelude to a series of rises in the coming months. Since rates were 6% when they started to come down nearly four years ago, there are fears they are about to start on the reverse journey. These fears seem unfounded.

While most of the news about the economy in the last month or so has been upbeat, much of it was, as British Rail used to say, ‘the wrong kind’ of growth. The first estimate of Q3 GDP growth was a healthy 0.6% – the second successive quarter of near-trend growth. The economy was, however, still too dependent on consumers. The 0.6% rise in September’s retail sales was slightly above expectations, implying spending was still rising annually at close to 5%. In the same month, lending to individuals rose by £10.7bn, or 14% annually, and personal debt is about 120% of incomes – a record.

Consumers and the services sectors have been the key drivers of growth for several years, but it has come at a price. The huge debt that has built up is currently affordable, but only if rates remain around present levels. Higher rates will put pressure on the consumer at entirely the wrong time. In the private sector, earnings growth has slowed and is now barely keeping pace with inflation. Just as increases in disposable incomes drop toward zero, the Chancellor’s higher NIC rates have kicked in. To increase debt servicing costs substantially in the coming months will put the squeeze on household consumption, which accounts for about two-thirds of all spending.

Weaning the economy off consumption may be what is required to rebalance activity, but only if there is something to replace it. At the moment, the evidence is fragmentary. Even though surveys are suggesting that optimism is growing among both manufacturing and service companies, which points to more broadly based activity next year, the UK’s trade deficit in September was £4.8bn (4.3% of GDP). The benefits of a global upturn remain elusive.

Sterling, moreover, needs to be competitive to help exports make a bigger contribution to growth.

The timing and extent of the policy changes are critical. If the MPC acts too soon and by too much, the consumer and sterling could be squeezed too hard and the recovery aborted. But, if its actions are too little too late, economic imbalances will mount and rates will have to rise even higher. In all, a small increase now is right and rates should be closer to 4% than 5% this time next year.