Fund manager's comment/Mark Parry
On 2 August, the Bank of England's Monetary Policy Committee surprised many people by cutting base rates to 5%. Was this, as some were quick to point out, a cut too far, or a correct realisation that rates were simply too high?
The subsequent positive reaction of the gilt market would seem to suggest the latter, but those of us with even short-term memories can hardly forget the warnings of the dangers of fanning the flames of the 'two-speed' economy by cutting rates. Perhaps more telling is the sharp change in future rate expectations. Money markets have moved from pricing in a series of base rate hikes starting later this year, to expecting at least the possibility of a further cut before the year end.
For some time now, the gilt market has been concerned about the apparent divergence in the UK economy between the manufacturing and service sectors and the consequent difficulty for the MPC to act without creating future inflationary problems.
Our long-held, and admittedly, oft-questioned, view has been that this was an over-simplification that failed to take account of the complex transmission mechanisms that operate across the different sectors of the economy. Manufacturing relies upon, and supports, various services during the productive process and employs people, both directly and indirectly, who in turn consume services.
Also, manufacturing grows, at least in part, as a response to demand for services, rather than in isolation and, as the data has been showing for some time, it also declines as that demand falls away. But the 'two-speeders' will say that it hasn't dampened consumption. 'Not yet' may not be a terribly convincing response, but given that the labour market is a lagging indicator of the economic cycle, this should not come as a surprise.
As unemployment picks up then retail sales will soften. Everything else being equal, lower rates should lend some support. But rather than look at the immediate effects of looser monetary policy, we should be asking why the MPC thinks that an easier policy is needed. Given the lags in policy effects, rates are being cut today to guard against future weakness, rather than to bolster any current strength.
Even if the authorities have got it wrong, the UK's inflation outlook should provide a significant element of support for worried markets. The Bank of England has a far greater capability and credibility to cut rates than the ECB, for example, which is hamstrung by its own inflation target. Indeed, in its short life, the MPC has shown the sort of transparency and pragmatism that has been one of the Fed's key tools in establishing Greenspan as the maestro of monetary policy.
In the debate about the UK economy, 'two-speed' really could mean slow and stop. A continued positive outlook for gilts beckons.
• Slowing growth as weakness broadens.
• Inflation below Bank of England's target.
• Low and stable interest rates.
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