Wednesday, 13 August 2008

The inflation report hints at rate increases

Today, the Bank of England published their quarterly inflation report. An initial reading of the document left me both perplexed and even a little intrigued. Is there a deeper message about the future path of interest rates that needs to be decoded? For what it is worth, here are my immdiate thoughts.

For me, the mystery starts with the inflation forecast. In terms of the future path of inflation, the message is blunt. It warns us to expect a further sharp increase in the autumn, followed by an even sharper retrenchment in 2009, bringing the headline rate back to the 2 percent target by 2010.

Bank of England - Inflation forecast, August 2008

The assumptions behind the first part of the forecast are easily identified. Input and output prices are accelerating, suggesting that in the short run, the headline CPI rate will continue to increase. So far, so good; this seems a reasonable take on the current situation.

The new year inflation turnaround requires a more nuanced interpretation. Why would inflation fall so quickly? Superficially, the BoE are pushing three explanations for their medium term forecast; lower fuel prices; decelerating food inflation; and the credit crunch.

The first explanation is certainly the most plausible. World oil prices are falling rapidly, and eventually, this will have a calming effect on the UK CPI. Unfortunately food prices show little inclination to moderate. The most recent data suggest that food prices increased over 13 percent.

As for the third explanation, the credit crunch as an anti-inflationary mechanism has been something of a disappointment. The UK is now one year into the new era of tight credit and prices have increased remorselessly. The banks have crunched their credit in a very focused manner. Collectively, they have munched on the housing market, while other sectoral lending activity has continued relatively unscathed.

Recent monetary growth data points out the selective nature of the credit crunch. In June, M4 was going at around 11 percent per annum. More generally, it is hard to see how double digit M4 growth rates are consistent with meeting the BoE inflation objective over the medium term.

Set against these three low inflation stories, there are three other reasons pointing in the other direction; sterling has weakened since last summer, pushing import prices higher, the fiscal deficit has grown dramatically during the first of 2008, strengthening aggregate demand pressures, and price expectations are rising, promising some inflation busting wage claims next spring.

Therefore, how can we make sense of the Bank's medium term inflation forecast? Well, there is one way. If the Bank of England were to begin an autumn campaign of interest rate hikes, their medium term forecast begins to look a lot more credible. Higher rates would tighten monetary growth and stabilise sterling. It would also warn wage setters that the current surge in prices is temporary and that the MPC is now determined to take control of the situation.

Is the Bank's growth forecast consistent with a couple of healthy autumn rate increases? Possibly. The Bank anticipates that the recent slowdown will continue well into next year. It also thinks that the UK economy will flirt rather dangerously that old boyfriend that she dated in the early 1990s - Mr. Recession.

Bank of England - Growth forecast, August 2008

However we interpret today's report, one thing is clear. Inflation is growing far more rapidly than the BoE anticipated. This point is borne out by a comparison between today's inflation forecast with one in the May report. The BoE had to hike their central forecast by at least a full percentage point.

Bank of England - Growth forecast, May 2008

Comparing the two inflation forecasts leads to another intriguing conclusion. The May 2008 forecast was based on a "no change" path for interest rates. As such, the decline in inflation was quite slow and moderate. The August 2008 forecast expects a much steeper and more rapid decline in inflation. Some positive action on interest rates would give some credence to the steeper adjustment path outlined in today's report.

Therefore, my money is on a brace of rate hikes this autumn. In the circumstances, with inflation racing towards 5 percent and beyond, it would be the right thing to do.


seema said...

If you are right, then the housing market is toast.

aSteve said...

I like the logic of your guess about the likely reason for the sharp turn in CPI and the simultaneous collapse in economic growth. Unfortunately, in the press session, this was explicitly denied. Mervyn King said that the forecasts for both CPI and GDP assume that interest rates do what the markets expect - i.e. that the interest rates remain flat.

The idea that the constraint would not come from central bank policy rates - but from retail rates - which are expected to continue to rise.

Alice Cook said...


I thought about that and realized that everyone else now thinks rates are coming down. However, I think I'll stick with my rate hike story.

The thing is that the BoE and others have been consistently behind the curve on inflation. Just take a look at the May forecast and compare it to the one today. They were way off.

I suppose my point comes down to this. I don't see what is going to bring down inflation.

My point gains more force when you consider the implication of suggesting that both forecasts are based on the samae interest rate path. How can that be? Three months ago you had 3.2 percent inflation and you think 5 percent rates will get you back to 2 percent inflation. Three months later, inflation is up at 4.4 percent inflation, with it probably going up to five within two months, and you still think that the same 5 percent interest rate path will get you back to 2 percent.

I detect a little inconsistency here.


Rob said...

I think it's more likely that they don't really know what they are doing and it's all pretty poor guesswork.

What's more interesting is how the MPC respond to fiscal stimulus by Darling and Brown to buy the electorate. Merv was pretty clear today that he opposes state support of the mortgage market.

I wonder if he'd resign on the issue of moral hazard or if he's basically a yes man.

Mark Wadsworth said...

Alice, look at the first chart - apparently, inflation will be back on target by early 2010, just in time for a couple of rate cuts before the next General Election.

BoE independence is a joke, and a not very funny one at that.

Edward Harrison said...

Alice, I find myself disagreeing with you for one of the first times here. The BoE wants to lower rates; they are just looking for an excuse.

After all, Mervyn King mentioned the possibility of recession and that the economy will broadly stagnate. There's no way they're going to raise rates in those circumstances. That would be suicidal with the economy heading into recession.

After all, inflation is well above target ad they haven't raised yet. They are just waiting for inflation to give them the opportunity to cut.

Anonymous said...

Thanks for this, Alice!

You pose a fascinating puzzle!

How would expectations about unemployment feed into the projections. I think unemployment rose by an average of about 20,000 each month from April to July - a very high rate of increase - and now stands at about 1.69 million.

The limitation of demand though accelerating house price falls and UK sub-prime losses will be augmented by rising unemployment. If that too starts to accelerate, we could be near, say, 1.85 million by the end of the year.

I think if unemployment by December is rising at 30,000 a month, Mr. and Mrs. Consumer will just batten down the hatches and hefty discounting will spread. That would make a good contribution to falling inflation in the new year.

If the rate may is to 50,000 a month by April, a total of 2,000,000 unemployed will appear soon after; all this that might nip wage demands in the bud next year.


B. in C.

Anonymous said...

P.S. The BoE report look to me to be avoiding the point about rapidly rising unemployment. On p. 27 the commentary tries to make a comparison with the benign slowdown of 2004-2006 when the job destruction rate stayed steady, but chart 3.6 shows that the that comparison is old hat already, with the job destruction rate already well above the 2004-2006 level and looking like it might go up in a near-vertical fashion as in 1991.

We all know the relevant comparison now is the early 90's slowdown. What's with these people???

B. in C.

ullrakesh said...

I love the article Alice, and agree with you on the rate hike as Merv King seems very keen on tackling inflation as a priority, and has made comments today about letting the housing market take its course without his intervention.

The bank has historically looked at 6% as the interest rate pain threshold and after lowering rates a little recently may feel they have .75% to 1% worth of room to maneuver.

Inflation however is being under reported % wise in key spending areas, and that will put real pressure on wage increases. This rapid rise in inflation will then get more fuel for the fire and the spiral will begin. When that happens input costs rise and the inflation fire is fanned further. Then we need higher wages, and so on...

A rate of 5% will not stop this spiral from happening so the only answer is that interest rates will go up, and I get the feeling that Merv King will show some real BoE independence in the face of an election, and give the politics of BoE independence its first real test.

credit savvy said...

it is avoiding the unemployment point
credit repair

Edward Harrison said...

here is my take on the BoE. I think they are doves now. Recession (and bank liquidity/solvency) is more important.

Markbaldy said...

Gordon Brown will keep interest rates low to prop up the economy/house prices using any excuse and underhand method dreamt up by his spin doctors.
If the BOE was truly independent, rates would have been generally higher for the last 10 years and their mandate of controlling inflation would have been actual instead of just words.
2% inflation...mmmm how many of Moron Gordon's Golden Rules have been broken now eh ?

Anonymous said...


I think you make the mistake of trying to make a rational analysis based on available data and a thought of what's good for the country.

The BoE is operating from the "any excuse to cut" playbook used in all recessions. Right now inflation is stopping them, but not for long.

Perhaps you can use your data mining skills to disprove me, but so far I think ALL recessions are characterised by rate cuts until recovery.


aSteve said...

Alice: "I suppose my point comes down to this. I don't see what is going to bring down inflation."

In the short term, nothing that the BoE could do would abate price rises... Cut rates and the currency depreciates - rising import prices. Rise rates and we won't see any further inflows of capital to fund further consumer/business/government debt. For UK business to thrive, we need lower rates - but our currency isn't up-to the punishment... at least, not yet.

To answer the question explicitly:

* Personal bankruptcies
* Business bankruptcies
* Rising unemployment
* Constrained government spending
* Falling global demand as every 'developed' country worldwide plunges into recession.

Falling interest rates are part of the recovery process - but we need to be sure that we purge first. I think we can do that at 5% - because this is higher than both the US$ and Euro rates. Raising rates, I suspect, while it would speed up the unpleasant nature of the shock... might do so to such an extent that it kills the patient. I'd be worried by any cut before Nov/Dec at the very earliest... or a cut while CPI is rising or is above 3%.

Edward Harrison said...

aSteve, your comments seem pretty well-balanced. Nick, I agree with you as well. On the whole, the UK has lots of room to cut in order o give the economy a boost. They are just waiting for the opportunity to do so, constrained by inflation as they are.

As soon as inflation starts back down and it is in a good range, they will cut - guaranteed. As aSteve says:

"Raising rates, I suspect, while it would speed up the unpleasant nature of the shock... might do so to such an extent that it kills the patient."

And the nature of this banking crisis says systemic risk is a real problem. The last thing the BoE wants is to trigger a banking collapse. They certainly wouldn't be independent after that.

By the way, inflation in the US just came out at 5.6%. With 2% base rates, Bernanke has more to worry about than King.

aSteve said...

Agreed, Edward.

The thing that is significant about the US$ is that it is the currency for speculation in global commodities - and, hence, it defines input prices for industry on a global scale. America can get away with this while they are the world reserve currency, but if they over-step the line the might loose the spectacular economic advantage they've had since 1946. If the world loses confidence in the US dollar (which I think is less likely than to retain confidence) the world will permanently change. The stakes are massive... but, while the US$ expands - and Sterling doesn't appreciate against the US$, our CPI inflation is heading up.

seema said...

Interesting observations. Those pictures seem somewhat inconsistent.