Corporate liquidity squeeze argues against rate hike

A deterioration in company liquidity should prevent the MPC from hiking rates this summer, according to New Star's Chief Economist Simon Ward.

Markets are now discounting two quarter-point rate rises in the UK over the next year but monetary trends show policy is already restrictive, according to Ward.

"The foundations of the current inflationary upsurge were laid in 2005-2007, when the broad money supply M4 was allowed to grow at a 12-13% annualised rate", he said. "To return inflation to the 2% target over the medium term, the rate of M4 expansion needs to be brought down to 6-8% pa. However, the slowdown should be gradual - a collapse in money growth would risk transforming a painful economic adjustment into an unnecessary bust."

M4 was still rising at an annual rate of 11.1% in April but has been inflated by financial transactions related to the credit crisis. An adjusted measure proposed by the Bank of England grew by 9.0% in the year to March (the latest available month) and at an annualised rate of just 4.8% in the first quarter alone.

This slowdown is contributing to a dangerous liquidity squeeze on companies, according to Ward. "Annual growth in M4 holdings of private non-financial corporations (PNFCs) has slumped from a peak of 16.1% last May to 1.0% in April. Relative to retail prices, real PNFC M4 is contracting at the fastest rate since the early 1990s, suggesting growing risk of a slump in business spending."

"With inflation and inflation expectations rising, the MPC has little choice but to sit on its hands for the foreseeable future. However, the Committee should resist pressure to compensate for its poor decisions in 2005 and 2006 by adopting an unduly restrictive policy stance now."