Are interest rates set to rise?
Whenever he approaches a bend, an F1 driver has to make a fine judgment: brake too soon and he loses vital momentum, too late and he risks losing control altogether, with possibly fatal consequences.
For the past year, the MPC has been getting closer to the bend – the point at which it will have to raise interest rates – so, as each month passes without a touch on the brakes, the balance of risk changes as the danger of losing control of inflation increases.
Unfortunately, this is where the analogy breaks down, because no racing driver ever has to cope with conditions as foggy as do economic policymakers. On the one hand, the signals from the real economy are mixed.The preliminary estimate of fourth quarter GDP showed a 0.5 percent contraction – but these estimates are prone to revision at the best of times, and with the exceptional weather conditions at the end of the year it is hard to have much confidence on this occasion. On the other hand, the inflation danger has been ever-present and growing, and the Bank of England’s 2 percent target has been more or less junked.
Consider the market data. If we look at the index-linked bond market, we see, on the one hand, a real rate which is zero or even negative and, on the other hand, an expected inflation rate rising from about 3 percent to above 4 percent over the next 20 years, which suggests only one thing: stagflation for the foreseeable future.
Against this, Bank of England apologists offer a number of decreasingly plausible excuses to explain why inflation is only a temporary problem, some of which amount to saying “it’s high because it’s high”. For example, blaming inflation on rising commodity prices in world markets is all very well, but if the value of the pound had risen on world markets rather than fallen, the impact on our own price level would have been far smaller – and the fall in the exchange rate is of course a direct consequence of the Bank’s own expansionary monetary policy (Quantitative Easing etc).
In fact, in our own modest way we have contributed to the rise in primary product prices, which has been mostly caused by the American version of QE, flooding the world (especially the Far East) with liquidity and generating a continual excess demand for soft and hard commodities, while the less prosperous parts of the Third World struggle to keep up with the cost of basic foodstuffs.
Against this, if there really is excess capacity in the UK, we should see the underlying inflation rate in the domestic economy falling or even negative. I differ from most of my profession, however, in questioning how much excess capacity we actually have at the moment, especially in the labour market. It remains easy and attractive for discouraged workers to drop out of the labour force into one of the available long term benefit categories (early retirement, disability etc), and the market will have been tightened somewhat by the clampdown on work permits for non-EU residents. Moreover, there are signs that the fall in the value of the Pound has benefitted the manufacturing sector (as it should), which is good news for the economy but will have added a little to inflationary pressures.
No doubt when the full impact of the cuts in Government spending is felt, the situation will change, but for the moment there is not much here to slow the inflationary bandwagon.
The market appears to be hedging its bets. On the one hand, it expects slow growth for the indefinite future as we struggle to pay off our debts. On the other hand, it has no illusions about our readiness to inflate them away, at least to some extent.
So what will the MPC do on Thursday? I would be very surprised indeed if they do anything beyond making the appropriate noises to try to convince us they haven’t taken their eye off the ball, which effectively means delaying the decision yet again. A Chairman of the Fed once said his job amounted to “taking away the punch bowl just when the party is getting started”. The current regime at the Bank of England (and at the Fed) seem to believe that there’s no need to take the punch bowl away until everyone is totally legless.