Friday, February 18, 2011

Will Higher Interest Rates Reduce Inflation

There has been much speculation about when the Bank of England may increase interest rates. With CPI inflation at 4% and RPI inflation at 5.1% (highest since 1991), many feel the Bank need to act to reduce inflation and maintain low inflation expectations.

For a long time, the Bank have dismissed the inflation as temporary inflation - due to short term, one-off factors such as tax rises, fuel prices, commodity prices e.t.c. However, this temporary inflation has lasted quite a long time. Therefore, inflation hawks argue, now is the time to act to reassure markets that the Bank are serious in keeping inflation close to the government's target.

However, if the Bank do raise interest rates by 1% in a few months, would it actually reduce inflation?

Higher interest rates increase the cost of borrowing, discouraging investment and consumer spending. Therefore, higher interest rates are effective for reducing demand pull inflation.

Higher interest rates increase the cost of mortgage payments giving people lower disposable income. Again this helps to reduce consumer spending. Higher interest rates can also act as a break on asset price inflation, (higher house prices can indirectly cause inflation through encouraging more consumer spending)

However, although the inflation rate is 2% above the government's target, it is hard to argue that the current inflation is due to excess demand. Wage growth is muted (annual growth of 2.2%). Unemployment is at its highest level since the early 1990s. After the deepest recession since the 1930s, the economy still has spare capacity.

Raising interest rates will probably reduce consumer spending growth. It will make the weak recovery weaker. But, will it tackle the commodity price inflation, we are currently seeing?

This graphs shows some of the different items within the CPI. This shows how rising fuel prices are one of the key factors in causing higher CPI.

fuel

Higher interest rates don't really effect fuel prices. Fuel prices are determined by international supply and demand. If UK interest rates rise, it will have an insignificant impact on the price of world gas and oil prices. (Gas and electricity inflation)

It may be that by the end of 2011, the Chinese and Indian economy will slow down. This would lead to lower demand for commodities and we could see the price growth stop. This would reduce UK CPI inflation. But, it would not be the result of higher UK interest rates. The UK economy is too small to significantly effect the price of world commodities. - Even a recession and slow growth in the US has failed to prevent rising commodity and fuel prices.

The MPC may feel obliged to raise interest rates but, the move would be largely symbolic having little effect on actually reducing cost push inflation.

The truth is that interest rates are not very effective in reducing cost push inflation. Just as cutting interest rates, in the liquidity trap of last recession was not very effective in causing a quick economic recovery.

In 2011, we *might* have a strong recovery. It is possible wage growth will pick up and economic growth exceed expectations. If this occurs, there would be a strong case for increasing interest rates. After all, the current interest rates (0.5%) are a response to the exceptional depth of the recent recession.

However, with falling house prices, cuts in government spending and higher taxes, it is difficult to see a return to a booming economy.

The MPC should continue to distinguish between core inflation and headline inflation. It is a lesson the ECB would be advised to follow too.

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1 comment:

Simon A. said...

The rise in commodity prices has been because of supply shortages in combination with growing demand from Asia. So only focussing on that: sure there is push inflation for commodities, making the interest hike inneffective. Yes, the recession has not made the demand side lower to such extend that it affects price.


However money parked at obligations/bonds for safety, is now moving because of also inflation fears. It's this lack of trust which makes people to move to real assets and leave paper, things that can hold and are good stores of value. These are commodities and precious metals. Looking at what Bill Gross was saying for months, and him being on the one of the first to move, I expect people to leave the bonds market. So it's not only the supply side that pushes, it's also the speculators (in commodities those roles are less seperated, tis the seasons that make all parties in the chain speculate, only some only want to trade in futures, without actually taking the goods to store it).