We ask industry figures....When should the Bank of England increase rates?

MAY 2011

Russell Silberston, head of global interest rates and PM, Investec fixed income team

The Bank of England’s Monetary Policy Committee is mandated to deliver price stability. This is defined by government as an annual growth rate in the Consumer Price Index  of 2%.

The committee’s job is to set bank rate in order to meet this target. They are pragmatic enough, however, to realise that inflation can deviate widely  and so aim to bring it ‘back to target within a reasonable time period without creating undue instability in the economy.’

The bank has consistently believed that spare capacity generated by the recession will bear down on inflation.

However, despite the deepest recession since WWII, this view has proved incorrect. Using their one-year forward Inflation Report projection, the Bank’s forecasts have, on average, been 1% too low.

While distortions such as the VAT increase have influenced inflation, the bigger picture shows an economy that has persistently high service sector inflation.

This has averaged 3.7% since 1997 and only weak  goods price inflation  has kept the overall level of CPI down. This has averaged just 0.5% since 1997 but recently has been rising rapidly as weak sterling and strong commodity price inflation combine to push prices higher. The overall effect is to force CPI higher.

There is mounting evidence that this is feeding through to expectations and behaviour. If the bank continues to cry wolf they risk dislodging these expectations permanently.

We therefore believe that a series of modest interest rate increases are now needed and forecast the first of these will be in May when bank rate will be increased by 0.5%.

NOT BEFORE 2012

Colin McLean, managing director, SVM Asset Management

Despite rising UK inflation, there is greater danger in unemployment and a sluggish economy.  There are already cooling forces at work on the economy; higher food and energy costs, and public sector cuts.  A relatively firm pound also constrains consumption. 

Although the next few months will see inflation tick up further, any token rise in interest rates would simply be to try to enhance the Bank of England’s credibility.  It would do nothing to cool imported inflation from commodities for which prices are set globally.  Any rise in interest rates might adversely impact the programme of public spending cuts, and it is the credibility of that programme that really matters to prevent a collapse in the pound.  I do not believe an interest rate rise is needed before 2012.

THIS YEAR

Ian Kernohan, chief economist, Royal London Asset Management

We think UK interest rates should and will be increased this year. There are two main arguments, firstly relating to growth and secondly to inflation. PMI data clearly show the economy continuing to expand at a reasonable rate, despite the rogue GDP figure last month and a torrent of negative press. Economic cycles often begin this way and even allowing for the very different circumstances which provoked the most recent recession, we do not think things have changed that much.

The global economy has rebounded strongly over the past year and it would be strange if the UK, as a medium-sized and relatively open economy, did not move in tandem. Strong global growth highlights the second argument for raising rates, namely inflation and, more importantly, inflation expectations. Pressure on energy and food prices resulting from strong global demand has helped to push up UK inflation.

Assuming the economy continues to grow and CPI remains above target, a modest increase in rates will help stabilise longer term inflation expectations. If we are wrong and rates do not rise this year, the most likely reason will be that growth has disappointed.

NOT BEFORE THE END OF 2011

Jeremy Batstone-Carr, director of private client research – Charles Stanley

When financial market historians look back they may discover that UK inflationary pressure peaked over the first quarter of 2011 as the full weight of the VAT hike conspired with rising commodity and energy prices to drive the year on year rate of inflation to 4.0% (double the target rate) in January.

Remember that the reversal of the VAT cut, in January 2010 only impacted on reported inflation over a number of months. It remains to be seen whether that happens this time.

While we expect inflation hawks to leap on the number as confirmation that the Bank of England is hopelessly “behind the curve” we are more sanguine.
The February Quarterly Inflation Report explains the Bank’s position in detail, specifically its view that it believes that inflationary pressure although elevated now, should prove transient and that the annualising out of the VAT hike in January 2012 should bring domestic inflation closer to its medium-term target.

Critically, we do not see wage growth accelerating and domestic unemployment is high, indicating a fair degree of slack.

Although one might fret about the apparent increase in the number of inflation “hawks” on the Bank’s Monetary Policy Committee we suspect that the majority will choose to “hold their noses.” If the Bank can withstand prevailing pressures then ultra-easy monetary policy will remain in place throughout 2011. Also, the UK’s aggressive fiscal squeeze calls for a monetary policy offset, in our view.