Will inflation soar when QE is withdrawn?

December 15, 2009

MarkBolsom - Mark Bolsom is Head of the UK Trading desk at Travelex, the world’s largest non-bank foreign exchange and international payments provider. The opinions expressed are his own. -

The rise in November’s CPI figure was larger than expected, but not a total surprise and markets have largely ignored the data.

In the Bank of England’s quarterly inflation report, published last month, Mervyn King reiterated his belief that short-term inflation looked set to rise quite sharply, in line with higher oil and petrol prices. There is little doubt as well that Sterling’s relative decline against a basket of other currencies has also contributed to inflationary pressure. This is particularly significant for the UK, as Britain remains a net importer of goods, and thus far there has been no sign of a reduction in the trade deficit. In fact the trade deficit actually widened to 3.2 billion pounds  in October from 3.1 billion pounds in September 2009.

In the short-term, we expect inflation to carry on rising, as the reversal in VAT, scheduled for January (currently at 15 percent, set to revert back to 17.5 percent), will add to inflationary pressures. As the pace of the global recovery picks up, we also expect the cost of raw materials to increase, further adding to upwards price pressure and quite possibly pushing inflation to 3 percent by the end of the first quarter in 2010.

Nevertheless, even with the pick up in underlying inflation, the higher CPI number is unlikely to significantly impact the Bank of England’s monetary policy. Mervyn King has stated that he will be focussing on the medium term outlook, preferring to concentrate on spending relative to the spare capacity in the UK economy. Given this outlook, and the probability that wage inflation is also likely to remain subdued, we expect the Central Bank to persist with a policy of low interest rates. We expect rates to stay on hold at 0.5 percent until 2011.

However, only when the MPC start to withdraw their quantitative easing programme will we get a true indication of the currently bolstered CPI figure. Thus, the real question is what will happen to inflation rates when the MPC start to withdraw economic stimulus?

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