Interest rates may rise again as the MPC tries to prove it's in control of inflation

Printers be warned. If you put up your prices, the Monetary Policy Committee (MPC) will raise interest rates further. That was the stark warning to business from the governor of the Bank of England Mervyn King, writing in the latest quarterly <i>Inflation Report</i>.

Even though CPI inflation fell from its target-busting and letter writing level of 3.1% in March to 2.8% in April, and RPI inflation eased from a 16-year high in March of 4.8% to 4.5% in April, interest rates are likely to rise still further before the summer is over. The MPC is determined to reassert its control over inflation and ensure not only that it returns to its 2% target but that it stays there.

Key to the Bank’s latest forecast was whether buoyant economic growth – in each of the past five quarters growth has exceeded 0.7% – and higher inflationary expectations would allow companies to keep passing on higher costs to consumers and increase wages. Although inflation has peaked, King insists that there are still risks to the upside. On regional visits, MPC members had seen for themselves that companies, in both the manufacturing and services sectors, were enjoying a greater ability to push up prices. The evidence on the ground is backed up by surveys, including the BPIF’s most recent Directions survey.

Charts and tables
The Inflation Report includes fan charts and tables showing what would happen if interest rates rose to 5.75% from July onwards. They show, even with interest rates at this level, that inflation over the next two years would be more likely to remain above the 2% target than fall below. The MPC has always been keen to show its forecasts as a range of possibilities; it regards economics as too imprecise a science to make point, or central, forecasts.

It may be difficult for the public to reconcile that interest rates should be rising at the same time as inflation is falling, but the MPC’s worry is that after the falls in gas and electricity prices have had their positive effect on inflation, non-energy prices may not remain relatively stable. While it is true that the high street and industry are more competitive than they were a generation ago, surveys of retailers and business managers reveal that they feel more confident about raising their prices than at any time over the past decade. It is this longer view of inflation that so concerns the MPC – it is determined to nip rising inflationary expectations in the bud.

Europe and the US
Reflecting its higher inflation rate, the UK now has the dubious honour of having the highest interest rates among the G7 countries. At their recent meetings, the US Federal Reserve kept rates unchanged at 5.25% while the European Central Bank held its rate at 3.75%. The Fed is trying a difficult balancing act reconciling slowing economic growth and core inflation that “remains somewhat elevated”. After seven months of unchanged rates, stability seems assured for some time to come. In contrast, ECB president Jean-Claude Trichet hinted strongly at his May press conference that a quarter point increase would be implemented in June.

There are reasons to fear that other factors that have helped keep inflation low in recent years are abating. The influx of immigrant workers into the UK may be peaking and the cost of Chinese imports is starting to rise as China revalues its currency. In addition, the medium-term outlook for the global economy is brightening. Once the US emerges from its current slowdown, it is possible that the world economy will enjoy a coordinated boom posing serious upside risks to inflation. As so often with economics, apparently good news is often accompanied by threats.

David Ross is an independent economics consultant running his own business, Ross Economics & Editorial Services. Contact him at: dh.ross@btinternet.com.