Horns of a dilemma

Interest rate is down to 5.25 per cent and there is another quarter point fall within sight. Good news for manufacturing, but Bank of England governor Mervyn King is fighting on the push-pull of two fronts and everyone knows his dilemma:will the rate cut recessionary brake fluid spill over and become the oil that fires rising inflation?
Last month’s CPI showed inflation at 2.2 per cent, almost in line with the Bank of England’s two per cent goal – for now that is. But higher prices for food and imports and the next wave of energy price hikes are set to push the CPI rate higher, says King.
Last April he had to write a letter of explanation to the then Chancellor Gordon Brown explaining why inf lation had breached the three per cent upper limit. Now, he is warning it is odds on, he will be penning his successor, Alistair Darling.
But with all the indicators showing a greater than expected slow down in manufacturing, the EEF welcomes the latest cut in interest rates. In particular it believes the looming chance of a recession in the United States, the credit crunch impact on business and consumer confidence, and a possible slump in the housing market, outweighs potential risks to the inflation target.
“The evidence from the past month points to a growing risk of a weaker economy. While the Bank is right to keep one eye on inflationary pressures, business will welcome the current measured and gradual approach to reducing rates,” says EEF chief economist Steve Radley.
Everyone acknowledges the Bank’s Janus-like stance. “If you look at what it is tasked to do – keep the rate of inflation down – it would probably have adopted a slightly different tone, and with a lot of inflationary pressures coming through in the economy, interest rates would have gone up,” says David Workman, director general of the glass manufacturers’ confederation, British Glass.
“But the overriding issue now is the fear of recession. And if the Bank had pushed interest rates up a signal would have been sent out that things were going to get tighter and a recession much more likely. A quarter of one per cent is not going to make much difference one way or the other, to industry or to consumption, and my view is it needs to be a far greater percentage. At the end of the day our sector’s products are consumer products, and if the consumer stops spending it’s going to rebound on us at some stage in the future. We would like to see measures that would stimulate consumer spending, and this means bolder rate cuts in the future,” – a scenario discounted by economist Ross Walker of Royal Bank of Scotland financial markets.
“I think another cut is coming. Mervyn King said recently that current rates were bearing down on demand and this seemed to signal some modest reductions. We will probably get another, perhaps to five per cent by May, possibly April.
But beyond that it becomes trickier. Short term inflation will be above target and rising, sterling has seen a significant deprecation over the last quarter, seven per cent lower trade-weighted, and both expectations and some survey evidence on pricing is a little bit too high for comfort. So I don’t think the Bank of England is going to be able to cut aggressively short term.”
But David Kern, economic advisor to the British Chamber of Commerce – which wanted a straight cut to five per cent – wants boldness, arguing that the threats to growth are now “much more acute than the risks of higher inflation,” a view backed by Peter Matthews, managing director of Black Country Metals of Stourbridge.
As president both of the Midlands World Trade Forum and the Black Country Chamber of Commerce, Matthews has the measure of the regional pulse. “Speaking on behalf of the Midlands international trade manufacturing sector with more than 700 members with exports worth over £2 billion I can say we are all of one mind, all at one point. The MPC have been very timid, and the problem we have with it is that every one of them is an economist, there’s no practical manufacturers there; nobody that understands the pain of the manufacturing sector. They are not taking into consideration the strength of the pound caused by high interest rates and the impact on imports and exports. We’ve got to be punchier and show the world that as well as looking after our currency we are also looking after our domestic manufacturing sector.”
China is the major market for BSA Machine Tools, Kitts Green, Birmingham, and with the Yuan linked to the falling US dollar, an increasingly difficult target for British exporters, says managing director Steve Brittan. “The interest rate has always been a blunt instrument, and trying to keep inf lation down using just this approach cannot work that simply, and it’s damaging our ability to export.
“I have just supplied $1.6 million of kit to Texas for the oil industry. We kicked off with a dollar rate suggesting around $1.75 and when we shipped the machines it was $2 – a massive penalty.
“When the customer requests quotation to reorder he can’t understand why there’s been such a massive price increase, and it comes down to the strength of the pound, driven by interest rates and the hot money flowing around.”
The US accounts for 15 to 20 per cent of British exports, and for some companies the slowdown there is a major issue. But Ross Walker sees demand in the EU (55 to 60 per cent) holding up and Asia remaining strong. “As long as this remains the case there will still be exporting opportunities, and the lower pound on a trade-weighted basis will help.” The growth of the Far East market is “great for us and the world economy,” says Roy Ayliffe, director of professional practice, at the Chartered Institute of Purchasing and Supply, “because there is no longer one power house but several. It spreads the risk.”
But UK manufacturing growth is slowing, with the CIPS figure now within 0.6 of its 50 ‘No Growth’ benchmark. “The biggest worry for our manufacturing members is the high cost inflation coming into them, and that inflation is worsening. They are having to change their approaches, for example reducing quantities bought in, changing buying frequencies, or holding less inventory.”
And the rise in global demand from countries like China and India brings inflationary as well as procurement issues. “There is always this balance of getting the things in sufficient quantity when they need them. For our manufacturers it’s a very difficult knife-edge position.”
A gradualist strategy of small step-change cuts is the right course, says Ayliffe. “Nothing dramatic as has happened in the United States. Their position is more worrying than ours, and for us, three more drops of a quarter over the first two thirds of the year would be about right,” an assessment broadly shared by Kevin Farrell, chief executive of the British Ceramic Confederation.
“Our view is very simple: the Bank of England should keep its nerve. A reduction in rates by a half or a quarter every month or so is more likely to be successful than large scale step changes. A determined but measured approach is the best
possible out turn.”
Farrell leads a notably diverse industry, from sectors like tableware – heavily dependent on consumer spending – and across to construction, notably bricks and tiles, dependent on house building and refurbishment.
“The exposure is twofold; firstly on the overall level of consumer spending, and perhaps more than that, the level of consumer confidence.” And as Farrell points out, big ticket consumers such as house buyers are looking for stability. “People want to know that within a stable situation whatever they commit to is likely to stay. High volatility doesn’t help.”
But for many manufacturers rising costs loom higher than modest interest rate movements. Around 90 per cent of overall chemicals production is exported, says Alan Eastwood, economic advisor to the Chemical Industries Association.
“Foreign exchange markets are playing a game of ‘guess where interest rates are going’, and if the UK looks likely to reduce them, sterling falls. That makes most UK manufacturers, including chemicals, more competitive. But UK chemicals have more concrete issues. Energy prices remain uncompetitive, and they are likely to be made much worse, on an EU basis, by the latest climate change proposals for more stringent emissions caps.
“Coupled with the burden of the REACH legislation, it’s not a good time for business in Europe. As a European employee of one of the
biggest US chemcos said at a recent meeting, his bosses in the US regard the EU as ‘closed for business’.”
For the British glass industry and David Workman, the ‘big but’ is the current energy price on the spot market and even year ahead prices. “It is of major concern to us. Last time round
when we hit these sorts of levels the industry wasn’t able to recover those costs through the pricing mechanism. If it has to go through the same process again over the next year or two, we could find ourselves in a serious position.”