Moving into recession?
With inflation running high and growth slow, should we be looking to raise the interest rate to reduce inflationary pressures, or lower it to stimulate growth?
Minutes from a recent Bank of England Monetary Policy Committee (MPC) meeting revealed that seven of the nine ‘wise men’ voted for interest rates to be held at 5 per cent, and in September the decision was made to hold rates for the fifth month in a row.
High interest rates, coupled with growth in the UK having been almost stagnant for the past two quarters, could potentially mean our current downturn may be in danger of devolving into something more akin to recession. A technical recession – i.e. two quarters of negative growth – is still a distinct possibility and it does not take Adam Smith to realise that further rate rises might just have tipped our economy over the edge. Yet lowering the base rate could potentially do just as much harm, allowing inflation to run riot!
Inflation is a sinister beast that if let loose devours savings, tramples consumer purchasing power and plays havoc with the country’s business confidence. In many ways, it is also of unpredictable nature. A month or so ago, the Economics Editor of The Independent reviewed the fluctuations of the Retail Price Index (RPI) since WW2 (the most consistently used measure). He found that in June 1948 inflation sat at 9.7 per cent; in September 1951 during a commodity boom linked to the Korean war it reached 12.3 per cent; by August 1971 it had fallen to 10.3 per cent but rose to 26.9 after the first oil shock in August 1975; in May 1980 it was 21.9 per cent and September 1990, 10.9 per cent. As of July this year the RPI stands at 5.0 per cent. It is worth noting that the Consumer Price Index (CPI) and not the RPI is used by the government to measure inflation and against which they target the Bank of England.
If we now stick with CPI figure but extract fuel and food costs, inflation drops to nearer 1.6 per cent. This is why the MPC does not have many choices open to it, because the sole weapon available to tackle inflation, namely interest rates, can take up to two years to have an effect. When food and fuel prices stabilise – which most forecasters believe will happen within 12 months, albeit at a distinctly higher level – or in economic parlance fully pass through the system, it is likely that inflation will drop as quickly as it has risen. As a result, rather than raise interest rates the bank will in the future need to lower them to stave of the expected slowdown, something I expect will happen towards the end of the year. Whilst not of much comfort to the millions currently struggling to make ends meet, I believe the MPC is steering the correct course.
There is one argument that says if we are so convinced that inflation will fall, why not cut rates? It is a very fair question however, cutting rates too quickly, in effect easing borrowing for businesses and consumers alike could stoke inflation in other areas. This could then adversely effect wage settlements, the current restraint of which at the time of writing is helping to contain inflation below 5 per cent.
So I am convinced that the MPC has been right to hold interest rates as long as it has and should do until November or December. Pre 1997 and especially during the 1960s and 1970s, the typical course of action in the present circumstances would have been for politicians to make knee-jerk and populist decisions – but these often caused long-term damage to a fragile economy. Given the inflationary challenges of previous decades things really aren’t as bad as they seem. We need to guard against short-term memories clouding our thinking, and consider the present situation as a sharp, one-off rap over the knuckles for the excesses of the last few years out of which the economy and well-run businesses will emerge all the stronger.
Kevin Reed is National Sales Manager – Vending with Siemens Financial Services.
