Sensible to hike base rate now

25 July 2011

Last month’s Monetary Policy Committee minutes revealed that only two members voted for a 0.25% rise in the base rate, suggesting that the prospect of a rise is still some way off.

The thinking behind the decision was expressed by Paul Fisher, executive director for markets at the Bank of England, in a speech on June 21. He indicated that the primary drivers of inflation were the price distortions created by the VAT hike and rising commodity prices. In short, once the VAT rise comes out of annual inflation figures and commodity prices stabilise, price growth will be negligible.

Fisher says underlying domestic demand is making almost no contribution to the price spiral which has pushed consumer prices index inflation over the government’s 2% target rate for 34 out of the past 40 months and threatens to take it above 5% before the year-end.

It is true that the 2.5% increase in VAT has skewed this year’s inflation figures upwards. Without it, the 4.5% figure for inflation could have been as low as 3%. The price of imported goods has also risen sharply this year, essentially as a result of external inflationary pressures and a weaker pound rather than rampant economic growth in the UK.

But while the argument that domestic demand isn’t running wild and that other sources of inflation are temporary in nature may be rational, inflation has appeared to ignore these facts for three years now with few signs of abating. Inflation expectations are an important component of future inflation as companies and workers factor their views on the latter into pricing of goods, services and wage negotiations. According to one measure, inflation expectations rose last month to their highest level in 29 months.

But in its Q2 quarterly bulletin the Bank argues that the current data suggest that long-term inflation expectations remain reasonably well anchored to the target.

With the economy mired in anaemic growth and high unemployment, it is no wonder that businesses and workers are unable to fully feed inflation through to end prices and wages.

Yet inflation is already impacting borrowers, in particular sub-prime ones, as wage stagnation coupled with rising food and gas prices effectively eliminate the small gap between those households’ income and expenses.

At Crown, we have already seen an upward trend in arrears and are gearing up for more of the same as inflation negates the benefit of low interest rates. Increasing rates and taking some of the pain now is a sensible option.

There are no guarantees that the growth-first policy will bear fruit and if it doesn’t, the Bank could find itself in a tight corner in the next few years where it is forced to push rates much higher than it would have to today.

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