Does lower inflation mean no interest rate rise?

Britain’s annualised inflation rate fell in March to 2.5%. That’s down from February’s 2.7% print and was lower than widely expected.

Britain’s annualised inflation rate fell in March to 2.5%. That’s down from February’s 2.7% print and was lower than widely expected.

It was also the lowest rate in a year, according to official data. This is a big trend change from the last two years when inflation has steadily risen.

Hard-pressed consumers will be feeling happier. Even better for them is the latest news that British pay packets are now growing by 2.8% per annum.

And because of that better inflation figure, maybe the Bank of England won’t raise interest rates in May?

Don’t be too sure. Rates should already be much higher than they are today…

Clothing cost rises curbed

The March UK CPI (consumer price inflation) drop was mainly due to slower annualised rises, i.e. to +1.9% from +2.4%, in prices of ‘core’ goods. These reflected a big fall in the clothing component from +3.9% per annum to +2.5%, while furniture price inflation also fell.

Enough detail. Why did core prices go up less quickly?

A lot of Britain’s consumer goods are imported. If the pound falls against other currencies, as happened after the Brexit referendum result, import costs rise.

But sterling has been recovering recently. In turn, that lowers import prices. “So the more plausible explanation is that retailers largely have finished raising prices in response to the depreciation of sterling in 2016”, says Samuel Tombs of Pantheon Macroeconomics.

“Core goods inflation has continued to track year-over-year changes in trade-weighted sterling with a lag of 12 months… [and] should continue to fall sharply, reaching zero by the end of this year and turning negative in 2019”, he says. “Core goods inflation accounts for 32% of the CPI, so a decline to zero by end-2018 will reduce the headline rate to 2%”.

In other words, the country’s consumer price inflation concerns could be easing.

Of course, that’s not the only form of inflation in Britain.

House prices look toppy

UK home values have been rising for at least five years. And they still are, according to yesterday’s UK House Price index data (as sourced from the Land Registry).

But the market’s slowing up. Prices nudged up by just 0.2% month-on-month in February. As a result, annual UK house price inflation eased from +4.7% year-on-year in January to +4.4%. That was the slowest growth in seven months.

And for the first time since September 2009, the Land Registry-based index showed London prices actually falling by 1% on an annual basis.
About time too, comes the cry from the rest of the country.

What’s more, the official HPI is suggesting faster house price inflation than the other main indices. In March the Halifax and Nationwide indices recorded house price inflation of 2.7% and 2.1% respectively. That confirms the downbeat tone of the latest RICS survey, one of the best forward pointers for British home values.

Put another way, the UK property boom could be drawing to an end, too.

“Looking ahead, we think UK annual house price growth will remain subdued over the next few years at around 1% – 2%”, says Capital Economics. “And with evidence that London is now turning into a buyer’s market, we expect prices [there] to fall further – by 3% across this year and by perhaps 5% in 2019”.

Where are interest rates headed?

So is this lower inflation, both for consumers and property owners, creating a conundrum for the Bank of England?

Next month the rate setters of the Bank’s Monetary Policy Committee (MPC) are widely expected to lift bank rate – which drives most other UK short-term interest rates – to 0.75% from 0.5%.

Might the MPC now mark time on raising the cost of money?

Not so fast. Don’t forget that 2.8% annualised rise in UK wages.
While UK household incomes are now growing in ‘real’, i.e. inflation-adjusted, terms again, there’s a potential problem here.

The Bank of England has always been scared about rising pay. This time will be no different. The MPC will also have an eye on UK unemployment, or rather the lack of it. The country’s dole queues are at their shortest since 1975. And hiring is continuing helter-skelter. Employees now have the upper hand in wage negotiations. That could mean pay climbing at an even faster pace.

The MPC already has enough evidence to raise rates in May. If the year-on-year increase in pay packets tops 3% this year, I expect to see several more hikes later on.

And there’s another good reason for more bank rate moves. As my colleague Jim Rickards keeps pointing out, this could be the ‘last-chance saloon’ time for central banks such as the Bank of England. They need to take the opportunity to raise borrowing costs now while there’s still some economic growth around.

That’s because, in the next recession – which may arrive more quickly than broadly expected – they’ll need to cut rates big-style to boost the economy again.

Let’s quantify what I mean.

To have a real impact on economic activity, the Bank of England will need to slice at least 3%, maybe more, off bank rate. The current 0.5% level is nowhere near high enough as a starting point. Cutting 3% off that would lead to negative rates of -2.5%.

Negative rates don’t work for a variety of reasons, ranging from dis-incentivising investment to damaging lending to distorting the whole economy. So the only workable answer is for the Bank, while it can, to lift bank rate above 3%.

Compared with history, this would still be low. But in today’s world which has become used to ridiculously skimpy rates, it would be a serious shock to the system.

I’ll talk about the likely fallout another day. One effect, though, would be some big waves in the currency markets.

And that could create some major money-making opportunities. So it’s over to my colleague Jim Rickards. Jim is a fanatical threat advisor for both the CIA and The Pentagon.

To find out more about his unique system, click here.

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