Inflation statistics released today showed that the CPI inflation measure has risen to 3.7%, well above the target of 2% and, above the consensus forecast of 3.5%. However earlier this month the Bank of England announced that not only would interest rates be put on hold this month but also for the foreseeable future to accommodate the new government’s fiscal contraction.
Given that the Bank of England’s specific remit is to keep inflation at around 2%, this announcement might seem a little surprising. CPI is currently the highest it has been since November 2008 when interest rates were at a rather more robust 3%. What is more, the Bank of England’s own statistics suggest that 72% of people expect prices to rise in the next 12 months.
Consumer expectations of inflation are something that the Bank should be concerned about. Over the last five years changes in the RPI (which is the measure of inflation most commonly used for wage setting) have closely followed consumer expectations. If inflation remains above target for a significant period of time the Bank’s credibility could be undermined, leading consumers to expect frequent price rises and ultimately leading to a requirement for much greater interest rate hikes.
Year on year changes in RPI, CPI and total weekly pay; and the percentage of people expecting price rises in the next 12 months
If inflation did continue to rise this would discourage investors away from the UK and lead to further falls in the value of the pound. Continued exchange rate volatility could also undermine chances of an export-led recovery as manufacturers and other exporters struggle to recognise price signals and market opportunities.
For the time being, however, the Bank is right to keep interest rates on hold. Primarily this is because the effects of fiscal consolidation are likely to dampen inflationary pressures in the economy. A combination of fiscal and monetary tightening would be likely to significantly limit economic growth.
In addition to this the Monetary Policy Committee consider many pressures on UK inflation (oil price rises, the VAT increase, and the depreciation of sterling) to be temporary. This could be masking a significant amount of spare capacity in the economy which, according to the MPC, will continue to pull down on inflation and may even bring it below target in the next year.
The MPC would be advised to remain vigilant, however. Core inflation has been growing steadily even in the recession; consumers continue to expect higher prices; and wages are on the up. As Mervyn King himself noted “the pace and extent of the prospective fall in inflation are highly uncertain”. If inflation doesn’t start to fall back soon, the bank may have to consider putting up interest rates – rather than risk its credibility – regardless of the fiscal situation.