Interest rate rise looks ever more likely

by Ed Bowsher on 18 January 2011  |  6 comments
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The latest inflation figures show that prices are rising even faster than expected. That means rising interest rate rises look more likely.

December’s inflation figures were much worse than expected. Consumer prices rose by 3.7% compared to a year earlier whereas economists had only expected a 3.4% rise. January’s rise will inevitably be even bigger as 20% VAT kicks in.

Rising prices for commodities – especially oil – explain some of the rise. But sadly, it looks like we’re facing a broader problem. The ‘core inflation’ number – which doesn’t include food and energy – is also up, rising from 2.7% to 2.9%.

Inflation has now been well ahead of the Bank of England’s 2% target for over a year. That’s potentially dangerous because it means that the man on the street’s expectations of future inflation may be changing. If your average worker thinks that prices are rising fast, he’ll want a bigger pay rise to compensate. Bigger pay rises would inevitably feed through to higher inflation.

Inflation expectations may also be changing in the City. I’m told that more and more people in the City fear that the government is deliberately stoking inflation. That’s because higher prices reduce the value of the government’s enormous debt.

Higher inflation expectations strengthen the case for the Bank of England to push up the base rate sooner rather than later.

However, the problem for the Bank of England’s boffins is that interest rate changes don’t make an immediate impact on inflation. In fact, economists say that the ‘lag’ between a rise and its impact is normally between a year and 18 months. So the Bank might push up the base rate now and then look stupid in 2012 if the economy has slowed down and inflation is well below 2%.

That could easily happen. Rising taxes and lower public spending will be a brake on economic growth this year – in fact, the Centre for Economics & Business Research (CEBR) reckons that growth will only be 1.1%. What’s more, trade unions could struggle to negotiate large pay increases when unemployment is rising.

So what now?

It won’t be an easy decision but my hunch is that the Bank of England will sanction a modest rise in the base rate by May.  As a result, many homeowners will be hit by higher mortgage repayments and savers will get a slightly higher return on their cash.

That said, I’d be very surprised if the base rate moved above 1% this year. A slowing economy will hold prices back eventually and the Bank of England will be keen to avoid a ‘double dip recession’ where the economy started to contract once again.

I’d also be very surprised if inflation went over the 7% mark. Some commentators were convinced that the Bank of England’s Quantitative Easing programme – where extra money was ‘printed’ – would inevitably lead to much higher inflation. In reality, Quantitative Easing helped to save us from a depression. Inflation at 3.7%, or a bit higher, is a reasonable price to pay for that.