Interest rates on hold despite inflationary fears

OPINIONS on the short-term economic outlook have not been this confused in a long time, and the confusion has rarely had such longevity. The public mood seems to swing from positive to negative depending on what particular number is published that day. But two recent indicators hint at the direction of interest rates in the coming months and the general condition of the economy.

The current debate has focused either on growth or inflation, either worries that activity is still weak or that prices are rising too quickly. Those more concerned with inflation favour higher interest rates to nip the price pressures in the bud, whereas those still unconvinced about the pace of growth argue that higher interest rates would undermine recovery. This uncertainty about interest rates is damaging for confidence in both the personal and corporate sectors. The picture seems at last to have become a little clearer.

There was probably a huge sigh of relief at the Treasury when the first cut of first-quarter growth was estimated at 0.5 percent. This reversed the fall in fourth-quarter 2010 GDP and indicated that the recovery had not been derailed. It did no more, however, than reclaim the ground that had been lost in the weather-affected final months of last year and, taking the two quarters together, pointed to an economy still in a fragile condition. Activity clearly still needs some encouragement – particularly from continued low interest rates.

A week earlier, the Consumer Price Index (CPI) showed a fall in the annual rate of inflation from 4.4 percent to four percent. However, April’s CPI figures released on 17 May returned to 4.5 percent. The inflation hawks feared that the rise in consumer prices would have a knock-on effect on wage settlements and the UK would get caught up in a wage-price spiral. The doves, on the other hand, argued that inflation was either imported (commodity and energy prices) or government-induced (excise duties and VAT) and higher interest rates were more likely to damage growth than curb inflation.

It now seems the balance of the argument favours the interest rate doves. The rise in GDP was not so fast, nor was the change in the CPI so marked, as to justify a change in policy. And there are reasons to believe that the inflationary pressures will ease. Currently, the annual increase in the CPI is running well ahead of earnings growth, thus depressing real earnings. This is exactly what higher interest rates do, of course, so why should the Monetary Policy Committee want to do it twice? There are enough deflationary forces in the system without increasing bank rate.

At the moment, the rebalancing of the economy that the authorities want is slowly underway. Growth can no longer rely on consumer spending or the public sector as it did for too long. Both remain boxed in by debt, and low interest rates matter to both. Instead, it is the corporate sector, and particularly manufacturing, that is leading the way. But the process has barely started and there are many more bumps in the road before we are back to business as usual. The fears about an inflationary spiral seem misplaced in the current environment and raising interest rates will send out the wrong signal about the authorities’ economic priorities. A well-balanced recovery along with sound government finances are the issues that matter most, even if the cost is that inflation is a little higher for a little longer than the target range.

There is, of course, no secret to achieving zero inflation. All the authorities need to do is grind the economy to a halt. If there is no activity, there is no inflation. Focusing on inflation when activity is still so weak – and before the full effect of the fiscal rebalancing comes into effect – runs the risk of pushing the economy down again. Inflation is not good for an economy, but a prolonged recession is even worse. Bank rate should stay on hold for the rest of this year.

Dennis Turner is chief economist at HSBC