Little chance of a rate hike until at least Q3

January 23, 2010

cr_mega_503_JaneFoley.JPGJane Foley is research director at The opinions expressed are her own. –

Bank of England Governor Mervyn King’s speech this week was well timed insofar as it has nipped in the bud a growing fear that inflation in the UK could be lurching higher.

King maintains that the present rise in the CPI is due to temporary factors.  As yet there is nothing in the rhetoric of King or in the minutes of Monetary Policy Committee meetings to suggest that the Bank is preparing to push interest rates higher.

As a consequence, there is still every reason to suspect that the Bank will be keeping rates on hold at least until the third quarter.

It cannot be denied that UK December CPI was far stronger than expected and that January CPI is likely to be even higher.

However, the temporary nature of the factors that are causing the surge (namely base effects linked to energy prices and the temporary reduction in Value Added Tax) suggests they should not significantly alter medium-term inflation expectations.

There is a risk that if headline inflation was to persistently exceed expectations that this may have a carry through into wage demands.  This risk cannot be dismissed out of hand because inflation last year failed to fall to the lows predicted by the Bank.

However, for now it is still likely that stable inflationary expectations combined with excess capacity in industry and high levels of unemployment should continue to bear down on wage deals and inhibit the ability of the retailer to pass on higher costs.
Fear of future inflation can be traced back to the depths of the financial crisis and the decision of some central banks (including the Bank of England and the Federal Reserve) last year to embark upon the policy of quantitative easing.

The apparent printing of money associated with this course of action supported the opinion that higher inflation must be a longer-term consequence of the plan.  One year down the road and there is next to no evidence to suggest that QE has prompted any a significant rise in inflation.

As in the Eurozone (where QE was largely avoided), growth in M4 in the UK remains very disappointing (-1.1 percent m/m in Dec) suggesting that the reach of QE into the real economy via the banking sector has lacked vigour.  Granted, cheap funds probably fed last year’s speculative rally in commodities such as oil which now being registered in the CPI, but underlying inflation in the West remains relatively low.
Energy prices remain a main driver of the rises in CPI.  In the UK base effect surrounding last year’s temporary reduction in VAT is also having an impact.  Insofar as both of these effects are likely to be temporary, inflation is likely to fall back to more moderate levels in a few months time.

Oil prices have already fallen 5 percent from their January high as the market reins back in its growth expectations for 2010 in the wake of disappointing U.S. economic data and monetary tightening in China.

Last year’s rally in oil was despite the fact that oil inventories remained persistently above their seasonally average.  This smacks of speculation.  In view of supply pressures, prices are likely to be more vulnerable to negative fundamental news than to positive going forward.

Stripped of volatile items such as energy, underlying inflation remains benign in the U.S. and the Eurozone and low in the UK.  The Bank, along with the Federal Reserve, may be out of the rate hike traps in Q3, since inflationary pressure have been even lower and interest rates higher in the Eurozone, the European Central Bank is likely to follow.

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