It seems so obvious. The Bank of England sets interest rates to hit the government’s 2% inflation target. Inflation is currently 2.3% and – despite holding steady in March – is certain to go higher over the coming months. Higher borrowing costs choke off inflationary pressure. Therefore interest rates should now be going up.
In reality, it is a bit more complicated than that. The first thing the nine members of the Bank’s monetary policy committee have to decide is whether the above-target inflation seen in the last couple of months is a temporary blip. It’s quite clear it isn’t. Food is going up, energy companies are raising their tariffs, retailers are passing on the higher costs of imports caused by a weaker pound.
Last month’s inflation figure was flattered by the timing of Easter, which led to a sharp fall in the annual cost of air fares. That one-off factor will be reversed in April. The question is not whether inflation will continue rising in 2017 but how high it will go. At least to 3% is the answer, perhaps a bit higher.
The next thing for the MPC to consider is whether there is a risk of inflation becoming entrenched. That would happen if rising prices led to workers successfully negotiating higher wages to compensate them for the hit to living standards. There seems little sign that inflation will feed on itself, as it did in the 1970s.
Paradoxical though it sounds, a combination of higher prices and stagnant wages is actually deflationary for the economy. That’s because living standards come under downward pressure, leading to consumers tightening their belts and companies investing less. The Bank doesn’t need to raise interest rates to bring down inflation. If it shows a bit of patience, inflation will come down of its own accord.
That’s provided there’s not another downward lurch in sterling because that would further raise the cost of imports and push the inflation rate closer to 4%. If the MPC sat tight under those circumstances, the financial markets might decide that the pound was a one-way bet and carry on selling.
That would be the nightmare scenario for the Bank. Rising inflation would intensify the deflationary squeeze on living standards but make it nigh-on impossible to ignore the case for an interest rate rise that would risk tipping the economy into outright recession.
So what does the MPC do? Simple. Members of the committee make hawkish speeches in which they explain how serious they are about hitting the inflation target. A couple of them even vote for a rate rise in the hope that the pretence of an early increase in borrowing costs supports the pound. Meanwhile, the MPC keeps its fingers crossed and hopes for the best.