Interest rate decision day: no news is bad news

February 11, 2011

-Laurence Copeland is a professor of finance at Cardiff University Business School and a co-author of “Verdict on the Crash” published by the Institute of Economic Affairs. The opinions expressed are his own.-

Whether their problem is narcotics or alcohol or simply junk food, addicts are usually planning to give up… but not yet. In the meantime, there are always plenty of excuses for delay.

And so it is for the Bank of England. The inflation rate will soon be double the 2% target, but they still judge it is too soon to raise rates above their current all-time low level. Moreover, yesterday’s announcement makes clear there is no end in sight for the gilt buying spree (the “Asset Purchase Programme”).

The Bank’s masterly inactivity is predicated on the MPC assumption that there is still plenty of slack to be taken up in the real economy. As I said here earlier this week, I am less convinced about the extent of the spare capacity in the UK economy today than they are, and hence I see far greater danger of further inflation than the Bank apparently does.

In any case, the key factor is expectations, where there are two constituencies to worry about. First, the further our inflation rate accelerates beyond its intended long run level of 2%, the more likely it is that workers will begin to build it into their expectations when negotiating their wages and, unless the Bank is right in assuming a large margin of spare capacity, employers will be willing to accommodate the higher wage demands, and inflation will take off.

But we also need to consider expectations in the international financial markets, which have so far been extremely patient with the British Government, appearing ready to give it the benefit of the doubt and pricing our debt so generously that the yield on long gilts is still only about 4½%.  However, if at any stage they lose confidence in the willpower of HMG and conclude that Britain has decided to inflate away its debt – in other words, to allow the domestic and foreign purchasing power of the Pound to fall – they will rush to sell, driving yields up sharply and costing us vastly more to service our debt. At that point, there will be no choice but to tighten credit drastically, since the alternative would involve an inflation spiral where we print money, the pound goes down and the markets push up yields, so we print more money and the markets push up yields even further…

The real beneficiaries of the current situation are the banks, who are able to borrow for more or less zero and lend at 5%, 6% – or even lend the money back to the Government at 4% or more. This money machine may be unavoidable if banks are to be allowed to rebuild their reserves, but it certainly is not an environment in which high street bankers need exceptional talent to generate profits, so there is no justification for the rewards they are currently being offered. In fact, if bank chiefs are indeed so gifted as to warrant bonuses in the millions, I suggest we replace them with men (or women) of lower calibre and pay them something more like average salaries. After all, you don’t need a Formula One champion just to drive a minicab.

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With the world economy as it is I struggle to understand how an interest rate hike by the BOE can assist in decreasing the rate of inflation. To my, (possibly very naive) understanding inflation, it appears to be being pushed up relentlessly not by the spending of the general public but by the ever increasing price of oil and so fuel, the increasing costs of: producing food, transporting food, tax increases and many other aspects which are totally out of the general publics control. I, along with every other person I know, am struggling on a day-to-day basis simply to get by with certainly no spare money to fritter. The low interest rates seem to be the only relief allowing people simply to exist not to mention the low mortgage rates that I believe have prevented an alarming rate of home repossession.

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