Market interest rate expectations have shifted dramatically as investors have reassessed near-term inflation prospects (discussed here). As recently as mid April, the gilt repo curve discounted a further fall in Bank rate to 4.0% by the end of 2008. By the time the Inflation Report was prepared in early May, the implied year-end level had risen to 4.6%. Poor April inflation data and the hawkish tone of the Report extinguished remaining hopes of reductions and the repo curve currently suggests a greater-than-50% probability of a quarter-point hike by December.

Market rates are now starkly at odds with economists’ forecasts, which have adjusted much less to recent news. In a Reuters poll conducted in mid April, 53 out of 56 respondents projected a further fall in Bank rate by the end of 2008, with a mean forecast of 4.43%. By mid May, the number expecting a decline had fallen to 45 out of 53, with the mean rising to 4.61% – still consistent with at least one quarter-point reduction. Strikingly, higher near-term expectations have been balanced by a lowering of projections further ahead – the mean forecast for the third quarter of 2009 fell from 4.37% to 4.33% between the April and May surveys.

So who is right – the market or economists? One way of approaching this question is to use the “MPC-ometer” model described in earlier posts to forecast Bank rate decisions over the remainder of 2008 assuming the economy performs in line with the MPC’s expectations. Specifically, suppose 1) GDP growth and CPI inflation follow the paths shown in the unchanged rates scenario in the May Inflation Report, 2) business and consumer confidence fall to levels consistent with the growth projection and 3) all other components of the MPC-ometer – including inflation expectations, earnings growth, equity prices and the effective exchange rate – remain at current levels. On this basis, the model indicates a 65% probability of rates remaining at 5.0% until the end of 2008, with a 35% chance of a quarter-point cut.

Put another way, economists’ expectations of one or two more quarter-point reductions before the end of 2008 depend on either growth and / or inflation undershooting the MPC’s forecasts or other components of the model shifting in a favourable direction. Neither seems particularly likely. The MPC’s growth projections are already downbeat, with GDP forecast to rise by just 0.9% in the year to the first quarter of 2009, while its expectation of a 3.7% peak in annual CPI inflation looks conservative. (This assumes a further 15% rise in retail electricity and gas costs but current wholesale energy prices suggest a larger increase.) Of the other model components, consumer inflation expectations and earnings growth are unlikely to fall back while the headline CPI rate is climbing, although a weaker economy may temper business price-raising plans. Lower equity prices and / or a rally in the exchange rate could boost easing hopes but neither carries strong weight in the MPC’s decisions, according to the model.

Monetary trends are also important for judging prospects for further rate cuts. Broad money M4 has continued to grow rapidly in recent months but appears to have been distorted by the credit crisis. Concerned about counterparty risk, banks have reduced traditional unsecured interbank lending in favour of secured loans, particularly gilt reverse repos. Unsecured lending is excluded from M4 but increasing repo activity may have boosted the aggregate because it is intermediated by the London Clearing House (LCH), which is classified as part of the non-bank private sector. The Bank of England has constructed a modified M4 measure excluding money holdings of the LCH and other financial corporations used to conduct interbank business (see p.18 of the May Inflation Report). This rose by 9.0% in the year to March and by 6.1% annualised in the latest six months (see chart) versus comparable growth rates of 11.9% and 9.6% for total M4. The gap between the two measures is likely to widen as a result of Special Liquidity Scheme (SLS) introduced in late April, which should significantly boost interbank repo transactions. It will therefore be important to focus on the adjusted measure rather than headline M4 to assess monetary conditions over coming months. (Unfortunately, the new measure is available only on a quarterly basis, with the next reading for June due in early August.)

Summing up, the MPC-ometer analysis supports market scepticism about economists’ forecasts of further Bank rate cuts later in 2008 but suggests a reduction is more likely than a rise. On this basis, current longer-term money market rates offer value – particularly unsecured rates, since credit / liquidity spreads should be capped by the SLS. Monetary trends are also consistent with a stable policy stance but a further slowdown in adjusted M4 would suggest improving medium-term inflation prospects, warranting consideration of a rate cut in late 2008 or early 2009.