8th October 2015
This is not a whodunit, so to answer the question straight away, is yes, it does look like the UK is overheating writes Bill Harer, head of fixed interest, credit research and UK linked funds at Canada Life Investments…
If this is right, it has serious implications for policymakers and the markets.
Looking at what has happened in the past 12 months, there are several pointers that suggest that the UK is overheating: strong job creation (400,000); unemployment down to 5.6% from 6.3%; rising average earnings; rising house prices – up 5.2% according to the Office for National Statistics, but it feels like more and a current account trade deficit of more than £100bn per year and rising – more than 6% of GDP.
There seems to be no let-up either; it was recently reported that net mortgage lending in August was the highest since the 2008/09 credit crisis.
At the same time, the government budget deficit is running at around £70bn per year (3.7% of GDP) and the Bank of England Bank Rate remains at 0.5%. In other words, still a loose policy mix.
Much of the comment from politicians and the media is about the risk of tightening monetary policy, but in fact the economy is seeing plenty of demand. If the UK is already running at full capacity, then the loose policy mix is simply pushing on a piece of string and stimulating job creation and demand in other countries.
Two key factors are persuading the Bank of England’s Monetary Policy Committee (MPC) to keep interest rates unchanged: low wage inflation and low consumer price inflation. But the risk is that these are simply being kept down by external safety valves.
Wage inflation has been kept low by the availability of an additional labour pool in other EU countries, while consumer price inflation has been held down by imports and cheaper oil.
The problem comes when policymakers focus too much on measuring inflation with the Consumer Price Index (CPI).
This is currently zero, but if you think about inflation in a broad sense, it is apparent that the prices of many goods are in fact going up. Supermarket prices may not be rising (or are they?), but money is chasing all sorts of assets that the CPI is not very good at tracking: houses, works of art, trophy cars, and so on.
So while the CPI is a lagging indicator due to those external safety valves mentioned above, other domestic factors suggest that there is already underlying inflationary pressure. This is exactly the same policy error that occurred in 2006 and 2007 in the run-up to the credit crisis.
Keeping an eye on inflation
What happens next? First, it should be noted that the MPC members are not universally dovish. At the August and September meetings, one member has started voting for an increase in interest rates. However, the majority of committee members clearly continue to favour no change. What could start tilting the balance towards tightening is that the CPI inflation rate is likely to go up soon.
In the second half of 2014 and into the spring of 2015, the headline rate fell from to -0.1% from 1.9%, a drop of 2%. Much of the fall was due to two one-off factors: the tumbling price of oil and the supermarket price war. Over the same period, the core CPI, excluding food and energy, only fell to 0.8% from 2%. Unless these one-off events are repeated, they will soon start to drop out of the year-on-year inflation calculation and the headline CPI rate will start to rise once again.
By the end of the year CPI inflation is expected to be 0.5%, then 1.5% by next spring. This is not runaway inflation but it would justify starting to move towards more normal interest rates. The rising headline inflation rate will also coincide with the introduction of the National Living Wage, which is expected to push up wage inflation. When this happens, it will start to ring alarm bells at the MPC and tilt the balance in favour of normalising monetary policy and encourage a move away from the era of super-low interest rates.
How soon is now?
Finally, instead of looking at the risk of raising interest rates now, it is worth turning the telescope round. If the Bank of England had started raising interest rates 12 months ago and we now lived in a 1% or 1.5% interest rate world, what would the economy look like? The answer is not much different. Domestic demand has been stronger than the economy can supply and sterling has gone up anyway, although house prices might not have risen quite so much.
The MPC discussed a rate rise a year ago, but then held off because of the sharp fall in oil prices. The committee is now going through the same process once again but this time around the key worry is the slowing Chinese economy.
The risk is that there will always be a reason to hold off but a key lesson of interest rate policy is that it needs to be pre-emptive; if the MPC waits until the inflation pressure is clear to all then it will be too late.