Economics - Higher, higher, lower, lower!

(From Financial Director)

Byline: Dennis Turner, chief economist at HSBC.

There is divided opinion among analysts on how high interest rates are likely to go - partly because it is hard to get an accurate picture of what is happening at the moment. While everyone is agreed on the final destination, it is by no means certain how far we are into the journey.

Economics students are taught about leads and lags, and about how long it takes for policy changes to have an effect. A favourite analogy used by many lecturers is to liken the effects of movements in interest rates to dragging a brick across a tabletop using an elastic band. To move the brick, it is necessary to tug on the band. At first nothing happens, but then the brick shoots across the tabletop and smacks the person in the face.

This is exactly what is happening with interest rates at the moment. The Monetary Policy Committee wants to move the brick, but how hard it has to pull on the elastic to achieve its objective is difficult to judge. Given how long it takes for rate changes to bite fully, it might already have done too much and the brick could be moving too far and fast, thereby inflicting some pain. On the other hand, a sharper tug may still be needed in the form of further rate rises to get the movement they want.

The MPC's remit is to ensure inflation stays within the target range (1-3%), and the recent pace of activity, with GDP growing above trend, suggests that prices will edge up in the coming months. The housing market, oil and other material prices, plus a tight labour market, are all potential routes by which inflationary pressures could re-emerge. Preventative action to slow the economy by raising interest rates can save a lot of grief later. The Bank of England has, therefore, raised base rates from 3.5% to 4.75% in under a year, and observers are looking for signs to see if the brick is responding to this tug on the elastic.

The signals have been confusing. Figures from the high street in August suggested some consumer belt tightening. The British Retail Consortium's retail sales monitor showed that like-for-like sales rose by less than 1% in August 2003. After the 3.7% annual rise recorded in May, the rate of increase fell in each of the three subsequent inquiries. This endorsed the findings of the CBI's distributive trades ...