Central Bank Conundrum

The nine member Monetary Policy Committee appear to be divided over the future direction of UK interest rates. Minutes for the February meeting showed three voted to increase rates, with Andrew Sentence recommending a 0.50% increase. Six members voted for no change, and Andrew Posen voted to add additional stimulus into the economy. On the face of things, with Consumer Price Inflation (CPI) running at 4% - double the Bank’s target – the natural reaction would be for the MPC to start increasing rates to bring inflation under control. However, the key fact to consider is that the increasing inflation is due to overseas and external factors that are beyond the Bank of England’s control. Increases in prices within the basket of goods and services that comprise the CPI index have largely been caused by hikes in the cost of raw materials (such as oil, cotton and grains) and increases in taxation (i.e. the recent VAT increase). Companies appear to have, by and large, passed on these increases to consumers. There is very little sign, if any, of wage inflation, which would be far more of a worry to policymakers.

The remit of the Monetary Policy Committee is two-fold – firstly, to aim to keep close to the CPI target of 2%. But secondly, and more importantly, to support Government policy and help meet targets for economic stability and growth. Given the fragile state of the UK economy (as seen by the contraction in the revised 4^th Quarter UK GDP data), I believe that any increase in Base Rates would serve to dampen demand and consumer confidence. However, the inflation hawks will point to the turmoil in the Middle East and the increasing oil price which may well cause inflation to climb even further above the Bank’s target. This may be enough to swing one or two Base Rate increases during the course of this year. However this will only bring the Base Rate back to 0.75% or 1% which is still very low in historic terms.