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How high's inflation, mama? 4% and rising...

    The Bank of England's inflation headache is looking increasingly like a migraine. CPI inflation is up to 4% in the year to January, and the more accurate RPI measure has increased from 4.7% to 5.1%, with the increases thought to be driven by commodity prices and the VAT hike. Economic opinion appears to be pretty consensual in suggesting that these results are likely to bring forward a Bank of England decision to increase the base rate of interest.

    Mervyn King's letter to the Chancellor seemed very downbeat. More than once he emphasised the deep divisions within the MPC over whether to tighten monetary policy, which perhaps suggests (as Emma Rowley states) that more dissenting voices are joining Andrew Sentance and Martin Weale in the call for a hike in the base rate.

    As highlighted on this blog before, there are considerable risks to both maintaining low rates or increasing them with the economy so fragile.

    The key here is that the MPC's whole purpose is to maintain price stability around the 2 per cent target. As Jeremy Warner points out, by appearing to ignore the inflationary pressures, they risk losing credibility. The Bank has had to write a letter in every month since November 2009 and it looks increasingly likely that they are going to have to signal their intention to act - particularly as King has now predicted that CPI inflation could rise to 5% through this year. It is difficult to see how a very small rate rise would have a significant adverse effect on growth. In fact, as Lord Lawson (£) rightly points out, allowing inflation to continue to rise could raise the cost of borrowing by more than a rate rise, if the markets fear a significant price spiral.

    The Bank's actions in the next few months will depend largely on how their medium-term inflation forecasts have been altered by today's data. If it remains convinced that the forecast based on market implied interest rate is below the 2% target, then as Hetal Mehta at DAIWA suggests, it will probably put off a rate hike until later in the year.

    But perhaps the most interesting aspect of today's figures was the reaction of George Osborne, who implied that he isn't significantly worried about the possibility of a rate increase. He said:

    "For its part, the Government's commitment to delivering its fiscal consolidation plan continues to provide the MPC with the space it needs to target low inflation."

    Ryan joined the Centre for Policy Studies in January 2011, having previously worked for a year at the economic consultancy firm Frontier Economics.

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