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.