28/04/2008
What dilemma?
There is a widely held view that the Bank of England cannot aggressively cut interest rates to counter the headwinds facing the UK economy because of prevailing inflationary pressures. Such statements seem to be endorsed by the surge in producer prices and deterioration in ‘inflation expectations’ this year. But just how imprudent would it be for the MPC to cut interest rates? Should it follow the example of the Fed, in aggressively relaxing policy, or the example of the ECB, keeping to a staunch anti-inflation stance?
CPI inflation at present stands at 2.5% a year, and has generally been above the MPC’s 2.0% pa target level since mid 2005. It is widely expected to approach 3.0% pa later this year, given raw materials costs are rising at their fastest pace since 1991, led by soaring food and energy prices.
Nevertheless, many companies still find it hard to raise prices. Consumers are economising on their non-food and energy purchases, forcing companies to lower prices to entice sales. Excluding food and energy, core inflation is running at less than half the 2.5% pa CPI rate.
What alarms some is that ‘inflation expectations’ are moving higher. These appear less driven by the Bank’s target CPI measure, more by the headline catching RPI. This stands at 3.8% pa, boosted by both mortgage payments and council taxes. Inflation expectations have risen sharply this year to around 3.7% a year, having remained steady throughout 2007 at around 2.7% pa.
There is a very good reason though to feel confident that inflation will not become a generalised problem, namely that wages and salary growth has not taken off. As MPC member David Blanchflower put it: ‘it is the dog that hasn’t, and won’t, bark’. While inflation expectations have risen, average earnings growth has remained steady at between 3.5% and 4.0% a year. The most recent reading was 3.75%, well below the 4.5% level that is generally considered to signal an inflation threat. Wage pressures have been eased by immigration, globalisation and by job security concerns.
As long as wage costs are not a ‘problem’, and economic growth slows to a below-trend rate, the MPC should not feel constrained in their policy decisions by fears about inflation.
Douglas Roberts, Senior International Economist at Standard Life Investments
This was published in Investment Week on 28th April 2008.
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