Interest rates Inflation scare

Interest rates Inflation scare

Aug 10th 2006From The Economist print edition
Why rates will rise again

THE Bank of England surprised financial markets on August 3rd when it raised the base rate from 4.5% to 4.75%. Its next step should prove less unsettling to the City. This week the bank indicated that a further increase is in the offing.
The bank signalled the rise in its quarterly Inflation Report, published on August 9th. This set out, as usual, both a central projection for inflation and the risks around it (see chart). The bank's main view is that if the base rate were to stay at 4.75%, the annual rate of consumer-price inflation would exceed 2.0%—the government's target—over the next two years. Since it takes that time for changes in monetary policy to have their maximum effect on inflation, the projection suggests the need for another rate rise.
The bank has become gloomier about inflation, especially over the next few months. According to the latest figures, consumer prices rose by 2.5% in the year to June, the fastest rate of increase (along with last September's) since the series began in 1997. The bank now thinks that further rises in household energy bills and still higher oil prices will push inflation up more over the next few months. And, towards the end of 2006, it expects higher university fees to add a quarter of a percentage point to inflation, something that was not included in previous forecasts.
As a result, there is now a big risk that inflation could rise above 3.0% around the turn of the year. If that were to happen, Mervyn King, the bank's governor, would have to write an explanatory letter to Gordon Brown. The chancellor of the exchequer requires this if inflation diverges from the 2.0% target in either direction by more than a percentage point. Since the bank was given independence to set interest rates in May 1997, this has never been necessary. But Mr King now thinks there is a 50% chance that he will have to write such a letter in the next six months.
A bigger worry still for Mr King is that the longer-term prospects for inflation have deteriorated. There are two main reasons for this. First, the bank now thinks there is less spare capacity than it did before. This follows the revisions to the national accounts made by official statisticians on June 30th, which raised the level of GDP at the start of the year by 0.7%. The bank accepts that there is a bit more slack in the labour market, which will temper pay pressures. However, it worries about surveys showing that companies face tighter capacity constraints.
Second, the bank does not draw much comfort from a likely moderation in energy-cost inflation. It fears that this will be accompanied by a recovery in profit margins and pay growth. A survey of companies by the bank's regional agents showed that profit margins had been squeezed in the 12 months to May and that this was contributing to a clampdown on wages. The bank's concern is that an easing in energy costs may cause a revival in pay pressures. It has unearthed evidence that over the past 15 or so years domestically-generated inflation has tended to move in the opposite direction to changes in import and energy prices.
The bank's hawkish line means that interest rates seem sure to rise by another quarter-point to 5%, probably in November. Whether they will rise beyond that is uncertain. Much will depend upon how strongly the economy continues to recover from its slowdown in 2005. The bank may be gloomy about inflation but it is upbeat in its forecast for GDP growth, expected to be close to its average rate in the past decade. That prediction relies, however, on optimistic assumptions about a pick-up in consumer spending, which grew in 2005 by only 1.3%, the slowest since 1992.
This week's stern report sends a clear message designed to reinforce the rate increase on August 3rd. Inflation may be rising but Mr King and his fellow rate-setters are determined to keep it under control.
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