MPC rate rises seem to have done the job - but it's hard to say why

In his last speech the governor of the Bank of England urged us not to read his lips, but rather to read the economic data in our attempts to judge the future course of monetary policy.

I have. Even a glance at the economic numbers illustrates that there is no need to tighten policy further. So much so that at the October monetary policy committee meeting there was no discussion of whether the repo rate should be raised from its level of 4.75%. There is a consensus that interest rates will be left unchanged again at Thursday's meeting. Can it really be the case that the peak in the UK's rate cycle is taking place at less than 5%?

We should first examine some of that data, showing that the economy shifted down a gear in the third quarter but there is significant uncertainty as to the causes of this. The growth rate in Q3 was less than half that recorded in Q2, and, at 0.4%, clearly below the trend rate.

This sluggishness arguably exaggerates the underlying weakness, because economic growth was dragged lower by a sharp decline in industrial production which is unlikely to be repeated in the current quarter. Nonetheless, with the housing market slowing and business surveys losing some of their lustre, the economy has shed momentum. I believe that growth will recover from the subdued rate seen in Q3, but only modestly so.

The MPC started tightening policy in November last year. Six months ago, in the run-up to the May meeting, the repo rate had been raised only twice and stood at 4%. Given that monetary policy is supposed to operate with a lag of 12-24 months, it is slightly surprising that the economy appears to be slowing already.

Several factors could be playing a role in increasing the efficacy of the recent policy tightening. The first is the oil price (and that of commodities in general). Producer price inflation is running at its highest rate in more than eight years. At the same time, retail inflation is benign with many goods continuing to fall in price. This situation is providing a (small) squeeze on corporate profitability, which could be depressing confidence and activity. Moreover, petrol prices at the pump have been rising: we estimate by 2% in October to their highest level since mid-2000, which will be acting as a mild drag on households' spending power.

A second possible explanation is the catch-all phrase "geopolitical uncertainty", possibly enhanced by the impending US presidential election. While not denying that economic agents - in the UK and elsewhere - could be inhibited by the current geopolitical climate, I do not find it a convincing explanation of the recent economic slowdown.

The third aspect to consider is that the labour market is no longer clearly strengthening. While the unemployment rate remains low (under 5% on the internationally recognised ILO basis), overall employment has not increased since the end of last year.

There has been a modest shift from self-employment to employees (partly reversing the impact of the past few years), which could be interpreted as evidence of robust corporate hiring. Nevertheless, the labour market data slipped enough for MPC member Richard Lambert to comment on it in his recent speech.

The fourth potential driving force is our old friend, the housing market. House prices have stopped rising over the last three months, for the first time in about four years. At the same time, mortgage approvals have declined to the lowest level in four years.

Like most analysts, I also focus on the Royal Institute of Chartered Surveyors' survey, which recorded a decline in its prices balance to the lowest point in nine years. Its ratio of house sales to the current stock for sale (akin to a crude demand-supply measure) also suggests a slowing market.

The feed-through from higher mortgage rates to a weaker housing market does appear to be more rapid than in previous episodes. There are probably several factors involved, including the higher levels of household debt, worry that rates could rise further and awareness by the public that house prices are generally overvalued and vulnerable to a correction.

There are two wrinkles in all of this. First, some mortgage rates (fixed products) have been edging lower once more, caused by the recent decline in bond market yields. This could act to support the housing market, akin to the episode of 1999-2000. Then, the housing market slowed as it is doing currently (the repo rate had been raised from 5% to 6%) but started recovering before the MPC began easing policy, although there was an expectation it would. I am dubious that will happen this time, but it is a risk.

The second wrinkle is that households have not just been running up vast amounts of debt; they have also been adding to their stock of financial assets. In aggregate, the household sector is still a net borrower, but by much less than the headline figures suggest. There is an argument that this will act as a cushion from higher rates. The issues involved are complex but, because this appears to reflect different households doing the borrowing and saving, the squeeze from higher rates on the latter will not be offset by extra spending by the former.

All in all, it is not fully clear why the economic data has softened. Moreover, we should note that households continue to spend freely in the high street, although this is partly due to price discounting and may be detracting from non-retail consumption.

Economic growth may well accelerate modestly from the Q3 level, but is unlikely to be strong enough to surpass the trend rate. Monetary policy is all about judging the various economic risks and, with inflation low and the housing market clearly slowing, the MPC has done enough.

We do expect that rates have peaked at the current level and, indeed, expect an easing in policy in the second half of next year. But that is a story for another day.

· Ciaran Barr is chief UK economist at Deutsche Bank in London