Rate expectations in the UK have been volatile so far this year. At the start of 2005 markets began to price in a rise in UK interest rates as likely, reflecting concerns of a reacceleration of domestic growth and inflationary pressures.
By the middle of the year, however, the consensus view, reflected in interest rate expectations, was that rates could be cut three times by spring of 2006. The market flipped round on the basis of voting patterns on the Monetary Policy Committee and indications that the Bank was becoming more concerned over the outlook for growth.
As it turned out, markets were right to expect a rate cut in August but, since then, expectations for further cuts in the near term have been pushed to one side. The close 5-4 vote in August's MPC meeting, with the Governor on the losing side, and a clear split between Bank 'insiders' worried about inflation (and opposed to cutting rates) and the 'outsiders' who worried over growth (advocating cutting rates) suggested that a near term stalemate would develop over the future direction of interest rates.
The release of the minutes of the MPC September meeting provided an update on the debate within the Bank. As expected, the Committee was unanimous in voting for no change in rates. Surprisingly, however, the minutes showed that members of the MPC did not even debate the need for another rate cut. It is striking that there was not a fuller debate over the need for further easing.
Like market commentators, the Bank spent a significant time debating the likely impact of high and rising oil prices. The Bank has concluded that risks in the near term point to further increases in the price of crude. This point is difficult to disagree with, given that Hurricane Rita could now compound the supply and refining constraints in the US oil market.
Interestingly, oil prices have recently been squeezing towards recent highs despite OPEC's decision to release all available spare capacity from next month. Markets currently fear a more significant impact from Rita on oil refining capacity than that which Hurricane Katrina inflicted. Their prognosis may well be right.
The MPC is now in deadlock, awaiting more information before deciding future moves. The debate on the impact of oil neatly summed up some of the main issues which the Bank is grappling with at present.
On the one hand, higher oil prices are likely to reduce disposable income, hit consumer sentiment and, ultimately, impact negatively on growth. Those on the MPC fretting over recent consumer weakness take the view that the energy induced shock from the oil markets will further undermine the sub trend growth outlook for the UK economy.
On the other hand, the hawks on the MPC, including the Governor Mervyn King, are concerned over future inflationary pressures as the corporate sector attempts to pass on higher input costs and as the consumer attempts to maintain levels of disposable income. In the discussion it became clear that an oil induced rise in inflation (which is already coming through) will lead to a mixed response from Committee members.
Accommodating a further rise in oil prices by cutting interest rates, regardless of a short term pickup in inflation, would prove controversial and we retain the view that the deadlock will remain until inflationary pressures alleviate, in the early part of 2006.
