Tuesday, May 10, 2011

Factors Affecting Interest Rates

Generally, central banks seek to target low inflation. The ECB target 2%. The Bank of England's inflation target is CPI 2% +/- 1. The most important factor in influencing interest rates is whether inflation is likely to deviate from this target.
  • If the Bank forecast inflation to rise above the target, they will increase interest rates to moderate economic growth and reduce the inflation rate.
  • If the Bank forecast inflation to fall below the target, they will cut interest rates to boost consumer spending and economic growth.

Temporary Inflation and Underlying Inflation

In some circumstances the headline inflation rate may rise above the target, but the Bank may choose not to increase interest rates. This is because they believe the underlying (Core) Inflation rate is still close to the target. (see: difference between CPI and Core CPI)

For example, in a period of commodity price inflation (e.g. rising oil price) or increased taxes, the Bank may view this is a temporary factor. In this case it may be more important to target economic growth and reducing unemployment - rather than the spike in headline inflation.

For example, in 2011 we have inflation rising about the target in UK, EU and US. But, this is primarily due to more temporary factors like rising oil prices, (and in UK higher taxes and devaluation). If we strip away factors that tend to be volatile, underlying inflation is lower and close to target. In 2008, inflation rose to 5% just before recession and RPI later become negative.

A key test is wage inflation. If wage inflation is much lower than the headline rate, this is an indicator that the temporary inflation is not feeding through into permanent inflationary pressures.

See: Does temporary inflation lead to permanent inflation?

Priorities in Setting Interest Rates.

The ECB have indicated that they consider targeting inflation to be the most important factor. Even if inflation is due to temporary factors, they prefer to increase interest rates to prevent any potential of inflation.

The UK has taken a more relaxed view regarding inflation. CPI inflation recently increased to 4.4% (well above upper limit of target) yet interest rates were kept at 0.5%. This indicates the Bank viewed inflation as a temporary phenomena and they were more concerned about weak economic recovery and persistently high inflation. However, this situation does prevent a dilemma for the Central bank; members of the MPC have been split on this issue.

Key Factors Influencing Inflation / Interest rates

  • Economic growth rate vs underlying trend rate. If the underlying trend rate is 2.5%, economic growth above this target is likely to cause inflationary pressure.
  • Spare capacity. A key test is the amount of spare capacity in the economy, though this can be difficult to calculate. For example, in a recession how much potential capacity is lost?
  • Wage inflation. Rising wages lead to higher costs for firms and higher spending. This is a very important factor as it can be self-reinforcing leading to a wage price spiral.
  • Unemployment. High unemployment tends to depress wage inflation and therefore keep inflationary pressure low.
  • Commodity prices. Rising commodities will tend to increase inflation. However, some commodities have a tendency to be volatile meaning it is more unreliable as a guide to underlying inflation.
  • Exchange Rate. A depreciation in the exchange rate will cause inflationary pressures. This is because imports become more expensive, and there will be greater demand for exports.
  • House prices. House prices don't directly influence the CPI. However, rising house prices causes a positive wealth effect and therefore higher consumer spending
  • Consumer confidence. Higher confidence leads to higher spending.

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