The MPC has left the official interest rate unchanged since the August Report. But market interest rates have fallen. The sterling ERI has declined by around 4% since August. Equity prices have risen, despite the higher oil price. House price inflation has eased. Narrow money growth has edged lower, but broad money growth has strengthened. Household borrowing growth remained strong.
1.1 Asset prices
Short-term interest rates
The Monetary Policy Committee (MPC) has operational responsibility for meeting the Government's inflation target. It does this by setting the short-term interest (repo) rate at which the Bank of England deals in the money markets. Since the August Report, the Committee has left the official interest rate unchanged at 4.75%.
Market expectations for the path of official interest rates over the next few years have fallen by around 0.5 percentage points since the August Report. Three months ago, market participants were expecting further rises in official rates, according to estimates derived from short-term market interest rates. But on 3 November, participants expected the official interest rate to remain broadly unchanged over the next two years (Chart 1.1). The latest Reuters poll of selected economists also suggests that respondents expected lower interest rates over the next twelve months than they did in August. On average, economists expected rales to be around 4.8% at the end of 2005, down from over 5% three months ago.
The ECB and the Bank of Japan have also left official interest rates unchanged since the August Report. In contrast, the FOMC raised the official US interest rale Iwicc during the same period, to 1.75%. Fulures contracts on 3 November pointed to gradual rises in rates in the euro area and Japan over the next two years. But market participants expected a more rapid tightening of policy in the United Slates, including a 25 basis poinl rise al the meeting on 10 November.
Longer-term interest rates and inflation expectations
Government bond yields offer a guide to market expectations of the official interest rate over the medium to long term. Medium-term rates have declined over the past three months. Between early August and early November, UK nominal forward rates three to five years ahead fell by around 35 basis points. And there were similar falls in the other major economies. But the fall in long-term rates in the United Kingdom has been less pronounced: UK forward rates ten years ahead fell by less than 10 basis points. At the same maturity, falls in the United States, and to a lesser extent the euro area, were somewhat larger. Measures of real yields, based on index-linked bonds and inflation swaps, have also fallen in all three economies.
The difference between yields on nominal and index-linked government bonds provides an indication of the inflation expectations held by participants in financial markets. In the United Kingdom, such measures have remained broadly unchanged over the past year, despite the rise in the oil price: Chart 1.2 shows implied inflation expectations for RPI and CPI in three to six years' time. There has also been little movement in survey evidence on inflation expectations.
Market-based measures of inflation expectations in the euro area have also remained broadly stable. Measures of US inflation expectations have picked up a little at the shorter end of the curve, possibly in response to the higher oil price, but remain relatively low. Economists' forecasts for US inflation in 2005 are little changed from August.
The sterling effective exchange rate index (ERI) is a measure of the UK exchange rate against a basket of other currencies, weighted according to their importance in UK trade. In the fifteen working days to 3 November, the sterling ERI averaged 102.1. That was the starting point in the MFC's projections, and was 3.9% below the equivalent average at the time of the August Report (Chart 1.3).
The fall in sterling could reflect several factors. In the absence of risk premia, market participants expect future changes in exchange rates to equalise returns across different currencies. So, other things being equal, an unexpected fall in UK interest rates should lead to an immediate sterling depreciation. Participants would then expect a faster appreciation than before - or a slower depreciation - to compensate for the lower returns on sterling-denominated assets.(1) The UK yield curve has fallen compared with other major economies since August, particularly at the short end. But this decline is not enough to explain the size of the fall in the sterling exchange rate.
Alternatively, the depreciation could reflect a rise in the risk premium associated with sterling, compared with other currencies. But it is hard to find corroboratory evidence from option prices for such an increase in the risk premium. Sterling's depreciation could also reflect longer-term factors. In particular, market participants may have become more concerned about the sustainability of the UK trade deficit, which has averaged more than 3% of GDP during the past year. These concerns may have been exacerbated by the modest underlying pace of recovery in LJK exports (see Section 2) and the United Kingdom's declining trade surplus in oil (Chart 1.4).
The FTSE All-Share index averaged 2301 in the 15 working days to 3 November - the starting assumption used in the MFC's latest projections. That was 6.0% higher than the corresponding average at the time of the August Report. There have been smaller rises in euro-area and US equity indices since August, and the Japanese Topix fell.
Between May and August this year, equity prices in the United Kingdom, the United States and the euro area moved in the opposite direction to the oil price (Chart 1.5). That suggests that financial market participants interpreted the higher oil price as a negative influence on profitability. But during September, both the oil price and the FTSE All-Share rose. What could have driven the pickup in UK equities?
Equity prices are affected by the future earnings that investors expect to receive. The fall in sterling should increase the sterling value of foreign currency earnings of UK companies. It should also improve the competitiveness of UK companies selling abroad, raising profitability. Earnings per share have risen a little since August. However, evidence from IBES shows that long-term earnings expectations have edged lower. Overall, changes in the prospects for earnings do not appear to be able to account for the full extent of the rise in equity prices.
Equity prices are also affected by the rate at which market participants discount future earnings. If this discount rale falls, equity prices should rise. UK real yields have fallen since August, which should lower the discount rate. In addition, it is possible that investors now perceive equities to be less risky. Any fall in the risk premium would also lower the discount rate, and boost equity prices.
The housing market
According to the Halifax and Nationwide indices, house price inflation has begun to ease (Table 1.A). For the first time in three years, both measures reported modest falls in house prices in October: the Nationwide index fell by 0.4%, and the Halifax index by 1.1%.
Different housing market indicators record activity or prices at different points in the house-buying process, as shown in Chart 1.6. The Halifax and Nationwide price indices for October relate to offers made around a month earlier, and those buyers are likely to have begun searching in the summer. Activity and price indicators at the start of the purchase timeline weakened in early summer, and remain weak now. In fact, a whole series of indicators along the purchasing chain (Table l.B) confirms the picture of a slowing housing market. However, the extent of the prospective slowdown in house price inflation remains uncertain.
1.2 Money, credit and balance sheets
The impact of the increases in the Bank of England's official interest rate depends in part on the pass-through to other banks' and building societies' rates. Over the past year, the standard variable rate on mortgages has risen broadly in line with the Bank of England's official interest rate. However, the effective rate - the average rate paid on the outstanding mortgage stock - has risen by less (Chart 1.7). That is largely due to fixed-rate mortgages, which are not affected by changes in the official interest rate.
Rates on some forms of unsecured borrowing, such as large personal loans, have continued to fall over the past year. Once special offers are included, the effective rate on credit card borrowing has also probably fallen. These falls are likely to reflect continued strong competition among lenders.