Interest Rates And Inflation: Will Rises Result In The End Of Cheap Money?

Brian Durrant - Fri 01 Jun, 2007

In February 2006, the Bank expected inflation to spend most of 2006 at 2% and stay there in the medium term with a Bank rate at 4.5%. By May inflation risks had mounted and a rate hike in August to 4.75% was agreed. By November rates were raised again to 5%; the Bank signaling that would be enough. Hence the rate hike to 5.25% in January 2007 was a surprise. This Februarys inflation report and the March inflation numbers made a further rate hike this month a certainty, while last weeks inflation report hinted at more rate rises to come. In the past year or so the Bank has tended to underestimate both the rise in inflation and interest rate response needed to quell it. This months May inflation report is a robust response to the challenges it faces...

In the past, Mervyn King the governor of the Bank of
England, has described the process of setting interest
rates in terms of the Maradona effect. He wasn’t
referring to setting rates by illegal means or by sleight
of hand, but in terms of his stunning second goal against
England in 1986. The great Argentinian footballer
bamboozled the England defence by feinting one way and
then the other while he himself proceeded in a straight
line. The Bank of England performed a similar feat in
between November 2001 and February 2003, when rates
remained steady at 4%, while at various times the markets
were looking for interest rates cuts or interest rate
hikes. Again from August 2004 and August 2005 rates were
kept on hold at 4.75% while from time to time markets
looked for either easing or tightening.

Now it is easy to play the Maradona game when the risks
of an economic slowdown or a pick up in inflation
pressures are finely balanced. In other words when a
feint left is just as likely as a feint right. But in the
last fifteen months steering a steady course and managing
market expectations has proved more difficult. In
February 2006, the Bank expected inflation to spend most
of 2006 at 2% and stay there in the medium term with a
Bank rate at 4.5%. By May inflation risks had mounted and
a rate hike in August to 4.75% was agreed. By November
rates were raised again to 5%; the Bank signaling that
would be enough. Hence the rate hike to 5.25% in January
2007 was a surprise. This February’s inflation report and
the March inflation numbers made a further rate hike this
month a certainty, while last week’s inflation report
hinted at more rate rises to come. In the past year or so
the Bank has tended to underestimate both the rise in
inflation and interest rate response needed to quell it.
This month’s May inflation report is a robust response to
the challenges it faces.

In the May inflation report it said that if interest
rates stayed at 5.5%, the Bank’s central forecast would
be for inflation to be above target and rising sharply in
two years’ time. So another rate increase is on the
cards, certainly by August if not before. Furthermore
interest rates will keep rising beyond that until
inflation is brought back to 2% and anchored securely at
this level. In other words the Bank is serious about
getting inflation back under control.

It follows that the Bank has made it clear that it will
err on the side of caution despite sharp falls in the
headline rate of inflation to come through. The 12-month
increase in the consumer price index should fall back
quite sharply over the next 6 to 12 months towards the 2%
target and possibly below. This will reflect not only
lower gas and electricity prices this year but also last
year’s energy price hikes dropping out of the 12-month
comparison. In the twelve months to March 2007 higher
electricity, gas and other fuel bills rose by 24.9%,
adding nearly one percentage point to the consumer
price index. However if you strip out utility prices,
the CPI has risen from 1.2% in October 2006 to 2.1% in
March 2007.

So news that the headline rate of inflation fell from
3.1% in March to 2.8% in April in no way prepares the
ground for interest rates cuts in the foreseeable future.
Underlying inflation pressures are still there. Of the 39
categories within the CPI, 24 have an inflation rate
above the 2% target.

To make matters worse inflation pressures could intensify
because of a statistical quirk unique to Britain. In
2003 the Bank of England was reluctantly forced to change
its target inflation rate to the Consumer Price Index,
ostensibly to harmonise with the Europe. It was
introduced as Gordon Brown’s sop to Tony Blair when the
Treasury rejected entry into the euro. Hitherto the
retail price index (RPI) had been the main gauge of
inflation in Britain for 50 years. Government
departments, employers and trade unions still use it as a
benchmark for setting wages, pensions and financial
payments, like the coupon on index linked gilts. Moreover
many believe that the CPI seriously understates the true
cost of living in Britain because it excludes such
crucial elements as council taxes and mortgage payments.

The problem is that in the past year or so the two
measures of inflation have diverged widely with the RPI
rate of inflation currently standing at 4.5% compared
with the CPI rate of 2.8%. In October 2005 the RPI and
CPI inflation rates stood at 2.5% and 2.3% respectively.
Moreover the expected fall in the CPI measure of
inflation in forthcoming months, will not be matched by a
similar decline in the RPI measure as the latter index
will incorporate higher mortgage costs that are in the
pipeline. Trade union bargainers and personnel managers
are increasingly aware of the growing gap between the
official inflation measure and the much higher inflation
perceived by ordinary workers.

Indeed if you look at the inflation picture in the medium
term, many of the restraining influences on inflation
enjoyed in the last ten years are starting to dissipate.
The high streets and industries of Britain may be more
intensely competitive than they were in the 1970’s and
1980’s but surveys show that business managers now feel
more freedom to raise prices than at any time in the past
decade. A point emphasised by Fleet Street Letter retail
expert Glynn Davis towards the end of last year.
Meanwhile the influx of immigrant workers may be peaking,
while the cost of Chinese goods is starting to rise and
will do so markedly if China eventually revalues its
currency. At the same time the outlook for global growth
is quite robust. By the end of 2008 the US is expected to
emerge from its housing market inspired dip, Germany is
reasserting itself as the locomotive of Europe and Asia
continues to experience explosive growth. All things
considered the risks to inflation in the medium term
remain seriously on the upside and the Bank of England
acknowledges that.

So those expecting interest rates to fall as headline
inflation falls this year will be disappointed. Interest
rates will certainly rise further and more importantly
stay high for a protracted period, leaving the markets to
feint one way and then the other. Cheap money is a thing
of the past just as someone takes over from Gordon Brown
at the Treasury!

Regards,

Brian Durrant
For The Daily Reckoning 

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