inflation, INFLAtion, INFLATION

19th January 2011

Another month, another over-shoot on expectations of CPI inflation – this time to 3.7% against market forecasts of 3.4%. The news has whipped up speculation about an interest rate rise sooner rather than later with all its repercussions for the UK economic recovery. Are UK consumers now going to face a situation where their household income is squeezed by inflation, their job prospects are squeezed by public sector cuts and their mortgage bills are squeezed by higher rates?

It certainly makes a good story. The Daily Mail has got middle Britain exercised about the prospect: . Chris RD in South Yorkshire says: "VAT up, Fuel Duty up, government borrowing up, inflation up, unemployment up, price of gas up, price of electricity up, cost of living up, and soon mortgages interest up – things just get better with the Tories."

The Telegraph says that the Bank of England is now under real pressure to hike rates: 

It is true that the bond markets are now pricing in three 0.25% interest rate rises before the end of the year. It also appears to be true that lenders are withdrawing their best fixed rate deals in expectation of a rise. What is less clear is whether an interest rate rise is necessarily the disaster it is billed. 

As Bill on the Daily Mail site points out: "As there are seven savers for every borrower, surely putting up interest rates will (finally) allow them to start spending money again thereby increasing the demand for goods and services, not reducing it as the screams of reckless borrowers would have us believe?" He has a point. There are plenty of people who would benefit from an interest rate rise.  

Simon Ward, chief economist at Henderson Global Investors, goes one step further to argue that interest rate rises could actually support economic growth rather than suppress it. He says: "Advocates of a rise in interest rates are not "inflation nutters" but believe action is required to prevent an upward drift in inflationary expectations that would worsen the output-inflation trade-off, thereby depressing medium-term growth prospects."

He says that the Bank's forecasting miss reflects stubborn core inflation, which continues to defy its prediction of a slowdown in response to economic slack and fading exchange rate effects. Equally, while it has become fashionable to quote post-tax inflation figures, these are also likely to understate ‘true' inflation because they are calculated on the assumption that indirect tax hikes are passed on in full to consumers.

The public has grown used to lower rates to the extent that rates of 1-1.25% now look daunting, but it is just possible that smaller rises in rates could be beneficial for certain sectors of the economy and for the well-being of the economy as a whole. Ultimately, rates have to normalise at some point. It will be uncomfortable when they do, but it is a necessary evil.

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