Keep rates low

Posted on 19 Jan 2011 by The Manufacturer

Roger Bootle, economic advisor to Deloitte, says the MPC should resist pressure to raise rates

Pressure is mounting on the MPC to raise interest rates in order to preserve its credibility in the face of above-target and rising inflation. However, I continue to think that the rise in inflation will be temporary and believe that interest rates need to stay low if the economy is to stand any chance of weathering the enormous fiscal tightening.

Admittedly, the near-term outlook for inflation has worsened further over the past month. Oil prices have reached $95 per barrel, wholesale gas prices have risen further and agricultural prices have reached new peaks.

Accordingly, CPI inflation looks likely to get close to 4% over the next few months, if not higher.

The MPC is understandably anxious that this will push up inflation expectations and hence wage growth. But evidence of a serious rise in long-term inflation expectations remains thin. What’s more, at a time when unemployment is 2.5m and likely to rise further as the public sector headcount falls, I doubt that wage growth will pick up even if inflation expectations do increase.

Raising interest rates by 25 or 50bps would probably not have much effect on inflation anyway. Indeed, if the rate rise was seen as an admission by the MPC that inflation is a serious problem, it could even have the counterproductive effect of reinforcing expectations of higher inflation. But at the same time, it could have a significantly negative impact on the real economy, not least by forcing up gilt yields and the pound.

Admittedly, the recovery still seems to have a decent amount of momentum. Although the CIPS/Markit report on services weakened sharply at the end of last year, this probably primarily reflected the disruption caused by the snow. Meanwhile, shoppers appear to have been out in force during the post-Christmas sales, making up for any shopping trips that were curtailed by the snow in December.

However, shoppers may not be so active once the VAT rise introduced on 4th January is fully passed on by firms. What’s more, in other ways, the economic recovery is looking more fragile. The boost to economic growth from net trade in the third quarter was revised away. The housing market is still weakening. And employment began to fall again in October.

Accordingly, I do not think that the MPC should be panicked into raising interest rates prematurely. Even if interest rates were increased only marginally, the resulting damage to the economic recovery could well mean that the rise would eventually have to be reversed again once inflation started to fall. Indeed, I stand by my long-held view that interest rates will be at 1% or below for years to come.

Roger Bootle is an economic advisor to Deloitte and the founder of Capital Economics