This morning, with the release of the MPC’s latest minutes, we discovered that a further member of the committee voted for a rate hike at the last meeting. Spencer Dale voted for an increase in the base rate of 25 basis points. That now leaves the votes: 3 to tighten, 5 to stay on hold and 1 to further loosen monetary policy (Adam Posen is still calling for more QE). The general tone of the minutes feels to me as though the committee in general is getting more hawkish and it’s becoming more likely that the base rate will be increased before too long.
One of the factors that the members of the MPC consider when making their judgments is inflation expectations. It seems pretty logical that if people expect inflation to be higher in the future, inflation will be higher – if you expect inflation to be 5% then when it comes to your annual pay review you will be looking for a 5% increase in your salary to maintain your standard of living. To meet this demand for higher wages companies will increase prices, inflation ticks up…….and so on. Well, at least that’s the theory. I’ve put this chart together to show how accurate inflation expectations have been at predicting what inflation actually turned out to be. I’ve taken data from a couple of surveys that ask participants what they think inflation will be in a year’s time and moved it on a year to show how their predictions matched up with reality.
I think the period from 2008 to 2010 demonstrates the problem with these surveys nicely. In late 2008 inflation was as high as 5%, at that point when asked what they thought it would be in a year’s time the median response was roughly the same level. Inflation was actually around 1% a year on.
As you have seen, since the financial crisis, expectations have not been a particularly good indicator of future inflation, therefore the recent talk of heightened expectations should have little, if any, bearing on the committee’s decision whether to hike rates. Let’s put them to one side for now.
The elevated level of inflation we are currently experiencing is being fed not by demand for higher wages, but by higher raw material/import costs. Monetary policy is a powerful tool but I think we’re fooling ourselves if we think that the Bank of England has any control over the price of oil for instance. Clearly they could hike rates to strengthen the pound, but in the process this would hamper our exporters – not a great way to stimulate a much needed domestic recovery.
Since the inflation pressure is coming from the supply side, increasing rates would, in my opinion, inflict even more pain on the British consumer. Whether the cost of goods (inflation) rises, or you increase the cost of the money used to buy those goods (interest rates), the outcome is the same – demand falls. I totally buy the argument for not letting inflation get away from us, but the risks on the downside to putting up rates in the short term far outweigh those to the upside, and should only be countenanced if wage pressures begin to emerge.