Philip Thornton: A memo translated from 'Mervynese' - the outlook for borrowers is bumpy but benign

For those of us who earn a crust guessing what the Bank of England will do with interest rates each month, 2004 was quite an easy year.

For those of us who earn a crust guessing what the Bank of England will do with interest rates each month, 2004 was quite an easy year.

The key to getting all 12 decisions right was to listen carefully to what members of the Monetary Policy Committee (MPC) said in speeches and testimony to MPs and to read the minutes of their decisions closely. I know this to be true (and apologies for blowing my trumpet) because that was what I did. A competition run by the One Account bank allowed journalists to enter their guess ahead of each decision, so the results were on the record.

To recap, Governor Mervyn King, sitting on the lowest rates for half a century, indicated in autumn 2003 that the Bank was minded to raise rates by a quarter-point to coincide with its quarterly inflation report. This it did in February and May.

The minutes of May's meeting hinted strongly that the MPC had wanted to raise rates by a half-point, making June a shoo-in.

There was one more hike in August and then the Bank signalled it was putting the shutters up. It was, as Mr King would proudly say, a "boring" year for monetary policy.

One reason was there was little disagreement between its members. Economists were wise to learn to speak "Mervynese".

We enter 2005 with the minutes of the December meeting ringing in our ears: "The downside risks to the inflation projection had increased, but not enough to make a persuasive case for a reduction in interest rates." This has rightly put the markets on notice for a cut. The minutes also hinted at a possible split on the MPC - something I hazard will materialise in the voting record before long.

With the January decision out of the way, it is time to stick one's neck on the block. I believe rates will end the year at their current level, but there will be arguments for hikes and cuts along the road. If anything, the balance of risks is on the upside.

Keep your ears to the ground but monthly decisions will be affected by six key factors. Top of the list is the property market, which is showing definite signs of weakening. Prices have posted the odd monthly fall, mortgage approvals are 40 per cent down on a year ago and estate agents report that buyer interest has dried up. On the other hand, prices actually rose in the fourth quarter of last year on both the Halifax and Nationwide measures.

The slowdown may be no more than high prices and general uncertainty deterring people from entering the market - rather than stagnation. With record employment, healthy wage growth and historically low levels of mortgage rates, it would take a shock to trigger a repeat of the 1990s crash. But if that happened, the Bank would probably be forced to react.

This feeds into the second issue: retail sales and consumer spending. The Bank has indicated it would not be too worried by a fall in house prices as it believes the link with spending has broken down since 2000.

The City is currently enjoying its annual hobby of warning of the worst Christmas sales in living memory, receiving support from the British Retail Consortium, which last week reported that December was the worst since at least 1993. On the other hand, the number of visitors to shopping centres post-Christmas has risen strongly, and Mastercard says the value of online sales has jumped 28 per cent, indicating that consumers have simply made virtual rather than physical shopping trips.

The MPC will prefer to wait for official retail sales data for December and January, which will not be available until after their February meeting. While it is too early to call, the death of consumer spending has been oft foretold.

The third factor is wage growth, with most deals being negotiated early in the new year. Since the summer, headline inflation has jumped from 2.5 to 3.4 per cent, and the average City forecast is for it to stay at 3.5 per cent until late spring. This is sure to feed into pay talks and could push average earnings, which also includes City bonuses, above the 4.5 per cent level the Bank believes is consistent with its inflation target.

Fourth, the MPC will keep an eagle eye on inflationary pressures in the pipeline. The cost of goods leaving UK factories recently hit an eight-year high, although it has since fallen back. The high oil price works on both the upside and downside: it adds to inflationary pressures but at the same time saps households' disposable income.

Another big unknown - and fifth risk - is the likely path of sterling. The pound's trade-weighted index has already fallen, thanks to depreciation against the euro, offset by a rise against the dollar. Further depreciation will add to inflationary pressures thanks to higher import costs. Whether that will happen largely depends on the dollar. The US currency is likely to fall further, but there are growing doubts if the UK can continue to be seen as a safe haven for dollar investors.

The sixth risk lies at the Treasury. Mr King has indicated that the Bank will act if Gordon Brown breaks his "golden rule" to balance the books over the economic cycle. However, Peter Spencer at Ernst & Young's Item Club has cleverly spotted that Mr Brown's ambitious GDP forecast of 3.0 to 3.5 per cent is based on a surge in exports and investment.

The investment growth relies on a 31 per cent jump in public sector capital spending, which conveniently lies outside the remit of the golden rule. In other words, Mr Brown can continue to add rocket fuel to the economy without breaching his rule.

Lastly, rates have not peaked below 5 per cent since 1952. There are some members who would not be happy with a neutral interest rate of 4.75 per cent.

Running through that list, the balance is on the upside. But the downside risks, which centre on housing, have the potential to wreak greater havoc on the inflation target.

This is no time for rough trade in Asia

Trade policy has a reputation for obeying the law of unintended consequences. No better example can be found than in South-east Asia, which has been affected not once but twice.

On the stroke of midnight on 1 January, just five days after the tsunami, a quota system governing the global clothing and garment industry was scrapped.

The 30-year system was originally intended to lessen the impact on the West of the opening- up of trade with developing countries by limiting exports from places such as India.

The unintended, but beneficial, consequence was to encourage manufacturers to set up garment operations from scratch in areas such Sri Lanka, Indonesia, Bangladesh, the Maldives and Mauritius.

Now the quotas are consigned to the scrapheap, China is set to capture half the global export market within five years, making life very hard for smaller, less efficient producers.

The result, the unintended negative consequence, will be a brutal restructuring just as these countries are attempting to rebuild their economies. The clothing industry employs 40 million around the world, most in poorer countries. In Sri Lanka it employs 350,000, supports a further million and provides half its export earnings.

Although pro-development groups support the abolition of the Multi-Fibre Agreement (MFA), they had warned about the impact on these countries well before the tsunami. Now the terrible images from the region have finally loosened purse strings, they are piling pressure on governments and companies to take action.

James Wolfensohn, president of the World Bank, is urging trade negotiators to "look carefully" - in the same way debt negotiators have looked at debt and offered some relief.

Free marketers should echo this. Research shows trade delivers greater benefits than aid or debt relief over the long term.

Oxfam estimates that Europe raises £70m a year from tariffs on Sri Lankan clothes and £95m from Indonesian textiles. It is urging the EU to grant free-trade access to those countries affected by the tsunami.

Non-governmental organisations (NGOs) want governments to provide cash to offset the pain from the hundreds of thousands of job losses expected, and to pay for diversification into other industries.

To minimise the impact, they also want Western corporations to tailor their plans to shift production out of these countries and into China.

UK companies which are big players in Sri Lanka, such as Marks & Spencer, should consider this very seriously. Oxfam has surveyed manufacturers and retailers which take 70 per cent of Sri Lankan exports both before and after the tsunami, to ask about their post-MFA plans. News of plans to shut down operations in an affected area in the wake of the tsunami could go down very badly at home.