Tuesday, 17 April 2007

The Bank of England needs to raise interest rates by 0.5 percent as soon as possible.

Today, the governor of the bank of England had to write a humiliating letter to the Chancellor explaining why consumer price inflation had reached 3 percent. It is now almost certain that the bank will raise interest rates in May. The only question is by how much: 0.25 percent or 0.5 percent.

It was the first time since the Bank of England gained its independence in 1997 that it had failed to meet the government's inflation target. The unexpectedly high consumer price inflation was surpassed by even more appalling retail price data, which also captures changes in mortgage payments. That index is now at a 16 year high and just a fraction below five percent. This index, which more accurately reflects changes in overall prices, will undoubtedly lead to higher wage demands, which will in turn exacerbate the inflationary spiral. The bank of england's measure of core inflation also offered no comfort. In March, that particular index had reached 2 percent.

The central bank now has a stark choice. It has to decide between reasserting control over inflation, or protecting the housing bubble. It cannot do both. As the Bank of England admitted in its letter to the Chancellor, the recovery in consumer credit during 2006 has contributed to higher consumer demand, and ultimately higher inflation. This can only be curbed by higher interest rates. As we all know, nothing kills a housing bubble than tightening credit.

Nevertheless, the Bank of England's letter expressed extraordinary complacency about wage growth. It suggested that wage pressures have not yet materialised. In a narrow backward looking sense, that might be true. However, with the retail price index running at 5 percent, and a tight labour market, workers are unlikely to accept real wage cuts implied by higher inflation and moderate wage growth.

Going forward, the Bank of England will regret any attempt to moderate the inevitable increase interest rates in the vague hope that workers have not noticed rapidly rising prices. If the monetary policy committee acts timidly in May and justs hike interest rates by .25%, this may well keep the housing bubble afloat for a few months longer. However, it almost certainly won't bring inflation back down below 3 percent. Higher wage growth will see to that. Inevitably, further interest-rate hikes will be forced upon the bank. The Bank of England needs to show that it is serious about inflation. Only a 0.5% increase in May will do that.


Anonymous said...

0.5 percent in May? I'm convinced.

hawkeye said...

The bank of england MPC is too spinless to consider a 0.5 percent hike. Your analysis might be right in a narrow economic sense, but it isn't realistic to expect anything more than 0.25 percent, if that.

Lets not forget we have just had an MPC meeting and what happened?


Anonymous said...

Soaring British inflation puts pressure on would-be PM Brown

Source: Agence France-Presse English Wire Date: April 17, 2007

by Roland Jackson

LONDON, April 17, 2007 (AFP) - British inflation spiked to a decade-high 3.1 percent in March, putting pressure on the Bank of England and finance minister Gordon Brown as he bids to become prime minister later this year.

Tuesday's inflation data forced BoE governor Mervyn King to write an unprecedented letter to Brown, explaining why British 12-month inflation breached a government-set ceiling of 3.0 percent last month.

He said that part of the increase was attributable to a rise in oil prices.

Political opponents of the Labour minister said that his economic credentials were now tarnished.

The data has cemented analysts' expectations of a British interest rate rise from 5.25 percent to 5.50 percent next month and pushed the pound above 2.00 dollars for the first time for 14 years.

An increase in interest rates will tend to attract short term money from abroad, increasing demand for sterling.

British Prime Minister Tony Blair, who will step late down later this year, staunchly defended Chancellor of the Exchequer Brown, who is widely seens as his successor.

"The remarakable thing is that this is the first time that the governor of the Bank of England has written such a letter," Blair told journalists gathered for his monthly press conference on Tuesday.

"I challenge anyone to name me a chancellor with a better economic record than this one."

Brown will face fresh criticism later on Tuesday when the main opposition Conservative party tables a vote of no-confidence in parliament over his 1997 decision to overhaul pensions taxation.

"This inflation rise is terrible news for Gordon Brown on the day that he faces his first ever no confidence motion," Conservative shadow chancellor George Osborne said.

"Whether it is the destruction of the pensions system or the broader performance of the economy, Gordon Brown's reputation for economic competence is unravelling before our eyes."

Although the governing Labour Party's majority in parliament should serve to ensure that Brown's position is not threatened, the attempt by the Conservatives may re-focus attention on his handling of the pensions issue in the run-up to local and regional elections early next month.

Brown has repeatedly defended his overhaul of pensions taxation.

Earlier on Tuesday, the pound touched as high as 2.0074 dollars, which was last seen in September 1992, while the European single currency hit a new two-year peak of 1.3594 dollars.

The dollar was also pressured by softer than expected US inflation data which increased speculation that the US Federal Reserve could soon cut American interest rates, which also stand at 5.25 percent.

The strong pound is a boon for Britons travelling to the United States because they can buy goods and services there more cheaply. However, it hampers British companies whose exports will be more expensive for customers using other currencies, particularly the dollar.

Britain's Office for National Statistics revealed on Tuesday that inflation had hit 3.1 percent last month, the highest level since 1997, underscored by large price increases for transport, food, non-alcoholic beverages and furniture.

"March's unexpectedly strong consumer prices data ... and the subsequent open letter from Mervyn King to the chancellor leave a rise in interest rates in May virtually certain and make a further tightening beyond May probably a bit more likely," Capital Economics analyst Jonathan Loynes said.

The reading significantly overshot analysts' consensus forecasts of 2.8 percent, which was also the official figure for February.

In his explanatory letter, King wrote that inflation had moved above target owing partly to increased crude oil prices.

"Since February, sterling oil prices have risen by around 25 percent, reversing part of the fall in prices seen in the second half of last year," King said.

"Higher petrol prices contributed significantly to this pick up of inflation in March."

He added that the central bank was "determined" to bring inflation back to the 2.0-percent target.

Brown wrote in response that he "continued to support the MPC in the forward-looking decisions it takes in the future."

hawkeye said...

UPDATE 1-Red faces for forecasters as UK inflation surges

By Christina Fincher

LONDON, April 17 (Reuters) - A surprise acceleration in British inflation has caused blushes not only for Bank of England policymakers but also for dozens of City economists paid vast sums of money to forecast data.

Figures on Tuesday showed inflation surged above 3 percent in March for the first time since comparable records began, prompting Britain's central bank to write an open letter to government explaining itself for the first time.

The Bank's failure to keep inflation within one percentage point of its two percent target has already drawn criticism from opposition politicians and trade unions.

But economists are not likely to join in. Not one of 36 polled by Reuters forecast inflation would rise so high. More than half expected it would either hold steady or fall.

Surprises every now and again are part-and-parcel of the business but forecasters seem to be making a habit of them.

Only one of 50 economists correctly predicted interest rates would rise in January and a surprise rate hike in August last year caused similar shock waves.

So is it simply that the economy is becoming harder to forecast? Yes, say many, who blame last year's energy price spike, choppy asset markets and even the weather for making economic forecasting more difficult.

``Forecasters are going through a particularly bad patch at the moment,'' said Michael Metcalfe, senior strategist at State Street. ``Volatile commodity and energy prices along with extreme temperature variations are making it harder to make seasonal adjustments, not just in the UK but in the U.S. as well.''


It is not just private sector economists that are having a tough time. The Bank of England's own forecasters also seem to be struggling.

In its inflation report last November, the Bank signalled interest rates may not need to rise above 5 percent to steer inflation back to target. Now, money markets are pricing in rates peaking at 5.75 percent.

``Inflation has risen higher and is looking sticker than we and almost everyone else expected,'' said Ross Walker, economist at RBS Financial Markets.

``Demand has been surprisingly strong and, since so many people have fixed-rate mortgages, it may be that monetary policy is taking longer to have an effect.''

A Reuters poll conducted after the data showed economists giving a 35 percent chance that rates will rise to 5.75 percent this year. This is more hawkish than the previous poll but still less than money markets which are pricing in such a move with an almost 100 percent certainty.

Bank of England Governor Mervyn King reiterated his confidence on Tuesday that inflation would fall sharply in the coming months. City analysts also stuck to their guns that the March reading was a blip and inflation would soon retreat.

And Chancellor of the Exchequer Gordon Brown

But can these forecasts still be trusted?

Over the past month, a raft of data has indicated the Bank is facing a more prolonged battle with inflation than it expected. Factory gate prices have picked up, house price inflation has gathered pace and retail sales have also rebounded after a surprise dip in January.

To be fair, the Bank has issued many health warnings over the accuracy of its forecasts, noting uncertainties over the economic outlook have increased. On this point, at least, it has proved accurate.

Patrick said...

.5 percent, you are obviously not a home owner otherwise you would realise that people who just wanted to get a home for their family are getting screwed by the starbucks crowd !