The publication of the Bank of England’s latest quarterly Inflation Report earlier this month created probably more confusion than clarity about the prospects for economic policy and interest rates. The statement, which appears on page 8 of the report, that “there was considerable uncertainty about the path of inflation, both in the near term and further ahead”, can hardly be said to be illuminating.
Correspondingly, there was a wide difference of opinion among economic commentators about the implications of the Inflation Report. Almost all commentators agreed that the Bank’s analysis indicated that there would be a further rise in the base rate from its current level of 5.25%, but there was no unanimity of views as to when this hike would be implemented. Timings ranged from March, through April or May, to an outside suggestion that the increase might even be delayed until August.
However, the publication of the minutes of the Monetary Policy Committee’s (MPC) February meeting appears to give a much clearer view of the prospects for interest rates in the near term. Yes, the meeting agreed to hold rates unchanged at 5.25%, but two members of the Committee, Tim Besley and Andrew Sentence, supported an immediate increase in the base rate of 25 basis points. Furthermore, the fact that the minutes record that most members thought it “appropriate to leave the base rate unchanged this month” suggests that it was only the timing of the increase that they considered inappropriate. It looks increasingly as though the base rate will be raised to 5.5% in March or, at the latest, April.
So what does this expectation of a further tightening in policy imply about the UK economy? The main conclusion has to be a certain surprise that the economy is proving quite so strong. Indeed, the strength of the economy has surprised everyone – including the MPC. The doves on the Committee have been shown to be over pessimistic about the impact that higher interest rates would have on demand. The hawks appear to have overestimated the dangers of inflation. This is particularly so after the publication of the consumer price inflation figures for January. As Governor Mervyn King so neatly put it, “just as 3% inflation [in December] did not mean the end of the world was nigh, so 2.7% [in January] does not mean that we can ignore concerns about inflation ahead.”
But excluding December’s rogue data, it does present a more convincing picture of a stable economy which is some way from breaching the upper limits of the Government’s target for inflation. All economic analysts agree that the rate of inflation will fall back to its target level. The argument now revolves around how far and how rapid this fall will be.
The hawks on the MPC remain fearful of the potential upward pressure on inflation from the robust nature of demand, which threatens to allow higher wage settlements and profit margins. They believe that an immediate rise in interest rates is required to return inflation to target within an appropriate timescale. But the doves on the committee continue to believe that there is no need to precipitate action. Rather, they consider that there is ample time to see whether the three base rate increases since August will prove sufficient to slow demand growth.
Given that the hawks appear to form a majority, the MPC must be expected to maintain its recent pre‑emptive stance and raise base rate next month. This seems the most appropriate choice to me. The earlier rates are raised and inflation is subdued, the earlier the subsequent fall in rates can begin. I remain optimistic that the base rate will be back at 5% much earlier than the money markets fear. n