This question was asked by anonymous reader via Formspring.
The table above is taken from the Bank of England’s latest Inflation report and shows the latest market expectations for the development of interest rates over time. As can be seen, the market expects rates to be 0.7% by the end of 2Q11, which suggests an 80% probability of a rise to 0.75% and a 25% probability of interest rates remaining at 0.5%.
I think interest rate rises are likely to happen later than many people currently expect.
Firstly, the above chart is the famous “fan-chart” from the same Inflation Report. It shows how inflation is likely to develop over time assuming interest rates follow the path currently expected by the market. Given the time-lags invloved in monetary policy, the Bank of England tends to focus upon the rate of inflation two years in the future. This currently suggests that inflation will be slightly below target in two years time, implying that the Bank of England can be a little more dovish with respect to its monetary policy than the financial markets are currently expecting.
Secondly, although inflation has increased above target, the Bank of England will be aware that higher interest rates are likely to have little impact on food and transport prices (the key area of upward pressure, together contributing 2% of the 4% CPI), beyond a one-off impact of a slightly stronger currency. These are problems with global supply/demand imbalances and beyond the control of the Bank of England.
Thirdly, if the impact of the VAT rise is stripped-out, then underlying inflation is much closer to target (the CPIY, which exlcudes indirect taxes, was only 2.4%yoy in January). Again, this is something that cannot be affected by interest rates and is a one-off effect that will drop-out of the figures from 2011.
Fourthly, the domestic economy is likely to remain weak for some time. with unemployment relatively high and the pain of the government’s fiscal tightening still to be felt. Consequently, I expect relatively slow growth from the UK economy in 2011, so I feel the risk of a wage/price inflation spiral developing is relatively low.
Finally, Mervyn King himself seemed to play-down the risk of an early interest rate rise when the Bank of England released it’s inflation report this morning, saying: “some people are running ahead of themselves and saying that we are pre-announcing or laying the ground for a rate rise. That decision has not been taken and won’t be taken until we get to the next meeting, or the following meeting – it may be many quarters before we do anything.” [Emphasis added].
- Bank of England inflation report to pave the way for interest rate rises (guardian.co.uk)
- Inflation hits 4% after January’s VAT rise (guardian.co.uk)
- Inflation report: Bank of England cuts growth forecast (telegraph.co.uk)
- UK inflation puts pressure on Bank of England’s Mervyn King to raise interest rates (dailymail.co.uk)
- VIDEO: King: ‘Inflation to stay high in 2011’ (bbc.co.uk)
- UK inflation jumps to 4pc, double the target (telegraph.co.uk)
- UK inflation highest in 2 years: Bank of England pressure to raise interest rates (dailymail.co.uk)
- King dampens early rates rise talk (guardian.co.uk)
- Bank Lowers UK Economic Growth Forecast (news.sky.com)
- The Bank of England employs witch doctors (blogs.telegraph.co.uk)