Forecasters have become more divided about the prospects for an interest rate rise in May after statistics showed that inflation fell back a little in March, although CPI is still well above target.
It cannot yet be claimed that the inflation problem has been tamed. CPI has been above target for sixteen months now and further energy prices rises are likely to keep it high. But this is not the only problem the UK faces. With large numbers out of work, households are facing a squeeze in both directions. The debilitating combination of sustained high inflation and high unemployment could severely hinder growth in the UK economy.
This risk should not be overstated. The ‘misery index' – a measure which combines the unemployment and inflation rates – is some way below levels reached in the 70s, the 80s, or even the early 90s. Though it may rise a little over the coming year, forecasts suggest it will fall back as the impact of the VAT rise subsides.
But this is not assured. The worry with inflation is that it – in itself – can cause more inflation. Workers see higher prices, and demand higher wages, this puts up costs for firms who then put up their prices: the so-called price/wage spiral. Avoiding this spiral is one of the reasons credible monetary policy is so important. If people believe that the inflation target will be met, they are unlikely to be too swayed by short-term increases in inflation.
As our pay survey shows, average settlements have not yet been too heavily influenced by inflation. They have risen from the lows seen in the recession, but remain well below the level of CPI inflation. This may not be because people believe in the Bank of England's inflation-fighting ability, however.
A weaker labour market means weaker pay demands. Unemployment is high, and government cuts mean that more jobs losses are on their way. The weakness of the labour market means that the MPC has so far been right not to raise rates. A lack of consumer confidence had led to muted household spending, which is a major component of growth.
The best policy response over the next few months is not certain. An inflation target that loses its credibility loses its efficacy too. And inflation has remained stubbornly above target. But the MPC's credibility on its assessment of the broader economy is also important. By raising rates too soon it could choke off the very growth it has so far tried to support. It is little wonder that the MPC have so far held the course.