Can inflation be controlled by raising interest rates?

January 13, 2010

MarkBolsom-150x150.jpg- Mark Bolsom is the Head of the UK Trading Desk at Travelex, the world’s largest non-bank FX payments specialist. The opinions expressed are his own.-

One of the Bank of England’s Monetary Policy Committee members, Andrew Sentance, was quoted this morning suggesting that the Bank of England will need to consider raising interest rates this year if a “recovering economy poses a threat to inflation.”

Sentance’s view that inflation will rise is consistent with our forecast and is also backed up by the recent upwards trend in the UK’s CPI Manufacturing data. A rise in inflation is unsurprising, given the Bank of England’s asset purchasing scheme, which aims to boost liquidity through printing more money. Inflation has also been bolstered by a weak pound, rising oil and commodity prices, as well as the return of VAT to 17.5 percent.

However, whether rising inflation can be controlled by raising interest rates, as Sentance suggests, is debatable. Historically, central banks have used interest rates to combat inflation, as they act as a brake on credit consumption – as rates become higher, credit becomes more expensive. Hiking up rates therefore offers the consumer an incentive to save, and reduces liquidity in the economy.

However, the current problem faced by the Bank of England is that raising rates above their current level of 0.5 percent will not have a positive impact on liquidity, because credit remains relatively tight. Although billions have been injected into the financial system, it seems that, thus far, this is still being used to build up balance sheets and asset prices. Relatively little has filtered through to consumers, and borrowing remains both restricted and difficult.

Similarly, increasing interest rates will not curb rising input prices in the manufacturing industry and eventually this sector will be forced to pass on these rising costs as they feel the squeeze.

It is also unlikely that the Bank will want to raise interest rates whilst Britain faces a period of extensive fiscal tightening. Due to the UK’s ballooning budget deficit, taxes are expected to rise and government spending is to fall. I think it would be far too premature for the Bank to raise rates against this backdrop of government spending cuts and higher taxes.

Therefore, while I agree with Sentance that inflation will continue to rise, I am unconvinced that the Bank will be able to control it using traditional methods such as interest rate rises.

The Bank now faces a crucial dilemma as their current economic situation is too fragile for them to exercise traditional methods of inflationary control. Interest rates cannot be raised whilst credit conditions remain tight and a huge budget deficit exists.

Potentially, all they can do is let the government control inflation through fiscal policy, with spending cuts and higher taxes. It would seem, then, that the Bank of England will from now on have to play a waiting game and assess the impact of the UK government’s fiscal response, before hiking up interest rates.

What do you think? Can the Bank of England control rising inflation through raising interest rates? Post comments below or post your thoughts on Twitter www.twitter.com/travelexfx

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