Tuesday, 22 February 2011

What is the trigger rate that finally forces the MPC to act?


At what rate of inflation would the monetary policy committee feel compelled to raise rates? It is certainly not four percent. We are there already and rates remain firmly fixed to the floor. Would it be five percent? Seven? Eleven?

There must be a number - a trigger inflation rate - where the MPC would finally act; a point where the costs of rapidly escalating prices are greater than any gains from protecting the banks and trying to revive the economy with cheap money.

Whatever the answer, the MPC have to deal with a rather unpleasant consequence of a near zero bank rate. The higher that trigger rate of inflation, the further the bank rate must travel before they can bear down on rising prices. If, say the inflation rate were cruising at a steady 7 percent a year, then a 25 basis point increase is unlikely to make much of a difference. The adjustment, if it is to be effective, is likely to be very nasty. There is always a cost for delaying the inevitable.

The crisis in the Middle East isn't giving any comfort to the MPC that it can avoid the trigger rate question. The oil price is swinging around violently with each political shock. Nevertheless, the trend seems unmistakable. Oil is at a two-year high. Today, Brent crude prices in London hit $105 a barrel today. If that price were sustained, then the Bank of England's central forecast of 5 percent will end up being a tad too optimistic.

It wouldn't be the first time that the Bank's optimism has led it to under-estimate external pressures on the CPI. Indeed, recent bank inflation forecasts have exhibited a strong bias towards under-predicting inflation. A cynic might suggest that these biases play a key role in rationalising the low interest rate policy stance of the MPC. The forecasts tell a pleasing story that lower inflation will eventually arrive, so long as everyone is prepared to wait out these recent external shock.

Instead of hoping for the best and pretending that inflationary pressures are temporary, the Bank needs to be looking closely at downside scenarios. For example, how would UK consumer prices react to political unrest in Saudi, with its inherent risks of disrupting oil supplies. What would happen to inflation if wage pressures in China were to increase?

Such scenarios cry out for a higher bank rate. They would also starkly illustrate that the magnitude of the interest rate adjustment will have to be large, thus exposing the MPC to the charge that it should have raised rates much sooner.

In fact, pushing rates down to zero was an over-reaction, largely driven by panic. It had a certain theatrical quality. The MPC acted like a magician, hoping to dazzle the audience with an unexpected trick.

With inflation now heading for five percent and possibly higher, the MPC might need to pull out their top hat and cape and prepare to play another trick with interest rates. How does a 300 basis point rate increase sound? Not shocking enough? Would 500 basis points be sufficient to have us gasping for breath?

7 comments:

Anonymous said...

Alice perceptive as usual.It is my belief they want inflation and are in competion with the USA and elements of the Euro block to achieve it.I think UK rates will be influenced more by USA and Euro rates than domestic inflation .
My dear old grandma used to say "actions speak louder than words".

Cornishgiant said...

I'm a non-ecOnomist, so please forgive my sins.

My question is this: if inflation is due to increases in commodity prices and there isn't equivalent rise in wages (which I still believe to be the case?) what effect will raising interest rates have? It isn't going to force down the price of oil, is it?

Anonymous said...

Cornishgiant, I'm not an economist either and I'm sure that Alice will give a better answer but I believe that the theory is as follows.
Interest rates fall, so external buyers of sterling lose interest and sell, reducing the value of sterling, which makes the cost of buying all foreign goods (including oil) more expensive for us. Therefore, raising interest rates should have an equal and opposite effect.
Maybe the number at which interest rates will be raised is not a CPI number but the number of protesters on city streets.

A David

Jim said...

Its all related to the previous post. If people weren't drowning in a sea of debt, then there would be no issue. Rates would have risen ages ago. Sterling would have responded, given we would have been among the first to raise rates. Higher sterling would then offset higher commodity prices.

We are now paying the price for our debt fuelled boom 2000-2007. I've always said the consequence of the boom would be the impoverishment of the UK population, via lower sterling and higher import prices, and stagnant wages. We are caught between the Scylla and Charybdis of rising inflation and/or economic collapse if rates rise to counter inflation.

It'll get worse before it gets better, exacerbated by idiot politicians who are doing their best to raise the price of fossil fuels beyond the market price rises by forcing everyone to subsidise 'green' energy. This is going to be a VERY hot political potato in years to come.

Elby the Beserk said...

I am absolutely no economist, but is it not likely that the interest rates are being held so low simply to protect the banking system? The MPC clearly don't give a toss that for many people the real rate of inflation is around 10% pa - ie. those whose spending is based around the essentials of food, fuel and energy?

Weekend Yachtsman said...

Check out Osborne's highly supportive remarks about King recently - this inflation is something the government wants.

They will act when the deficit has been inflated away to a level they feel comfortable with; work out how many months it would take at whatever rate, to double prices (or halve debts) - it's not that long once the rate gets up near 10%.

Those of us who have savings and pensions will then have been dispossesed to pay for Gordon Brown's extravagance.

Plus ca change...

Flynn said...

Whilst the immediate change is in confdidence, exchange rate, etc, conventional wisdom is that the impact of such "adjustive" interest rate changes takes 18 months to work through. That is another 12-15 months of inflation with little wages bargaining power. However, it seems the real policy is to inflate away the supposed increase in personal wealth over the last ten years and take us back to where we proabaly ought to have been except for the property bubble. So much for "my house value rose by 30K last month"!