Sunday, February 06, 2011
Bank under pressure as inflation hits home
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.the sundaytimes.co.uk. This is an excerpt.

After all the uncertainty generated by those fourth quarter gross domestic products figures, followed by stronger survey data for January, who could vote for an immediate hike in Bank rate?

Well, step forward for a start the “shadow” monetary policy committee (MPC), which meets under the auspices of the Institute of Economic Affairs. Its latest vote, ahead of the actual MPC’s vote this Thursday, is 5-4 in favour of an immediate Bank rate hike to 1%.

The five hikers, Philip Booth, Kent Matthews, Patrick Minford, my near-namesake David B. Smith and Peter Warburton, who have pushed the shadow MPC to its first decision to hike for three and a half years, are worried on several fronts.

They think continued above-target inflation is badly damaging the Bank’s credibility, that rapid growth in the world economy will continue to impact on prices in Britain and that, as pointed out here last week, the pound cannot be regarded as independent of monetary policy.

Sterling’s weakness in the past three years, in other words, at least partly reflects the Bank’s stance. That weakness has been a big factor pushing up inflation.

Interestingly, given Mervyn King has cited it as a reason not to raise rates, the majority on the predominantly monetarist shadow MPC does not believe weak money supply growth is a good enough reason to hold back from hiking rates.

Shadows are just shadows. What matters is what the actual MPC does. We know, barring an economic avalanche, Andrew Sentance will vote to hike, as he has done since June. His colleague Martin Weale voted to raise last month but says he will take stock of the GDP evidence before deciding in a “pragmatic” way whether, as seems likely, to stick to his guns.

What would it take to swing the whole MPC over to a hike? Some people appear to think it should never do it. I was astonished to read a letter in the Financial Times from two economics professors concluding “it is clear that raising interest rates has no role to play in bringing down inflation”.

There may be times when the interest rate weapon is blunted but to argue that changing interest rates has no effect on inflation is extraordinary and against the overwhelming body of evidence.

As for the MPC, for those who need a refresher, there are four “external” members, people appointed from outside, though while on the committee they work three days a week at the Bank.

Sentance and Weale are external members. So is Adam Posen, who looks to be in the opposite camp on rates, favouring more quantitative easing. David Miles, the other “external”, has so far not shown any inclination to join the hikers.

As is clear, no hike in rates can happen without the support of some of the Bank’s five “internal” members, full-time Bank employees, who make up the majority on the MPC. They are the governor, his two deputies Charlie Bean and Paul Tucker, Spencer Dale, chief economist, and Paul Fisher, executive director for markets.

Unless I have misinterpreted King’s speech - in Newcastle, not the film - he will not be in the hiking camp for a long time. Will any “internals” vote against him?

It has happened before, most famously in August 2005, when Bean voted with the four externals, and thus against his Bank colleagues, to cut. Bean has now warned that persistently high commodity prices could force the Bank to act to cut domestically-generated inflation to compensate.

More recently Dale voted for less quantitative easing than the rest of the MPC, including King, wanted. The internal members can vote against the governor without the Old Lady losing their dignity.

Will they this week? There is a point when the Bank runs out of excuses. MPC members said they would worry if higher inflation was reflected in inflation expectations. That has happened. They said they would worry if pay settlements moved higher. That is tentatively happening, with Incomes Data Services reporting provisional median settlements of 2.6% last month, up from 2.2% in December.

There comes a point when, as King noted in that speech, the effect of rising prices is to squeeze incomes and hit growth. You then have to ask whether the effects on growth of a modest rise in interest rates are worse than those of tolerating persistently high inflation.

Markets have started to anticipate higher rates, discounting a rise to 1.25% by the end of the year. Gilts (government bonds), whose performance since the May election has been encouraging, have started to suffer on inflation worries. The kind of rise in gilt yields we have seen recently often presages a hike in Bank rate.

But this week? Anything could happen. In January the Bank’s minutes noted that several of the members who voted to hold saw it as “finely-balanced”. February, with a new inflation forecast, would allow a more thorough analysis of the risks.

It still looks a little early to me for the majority to swing, and it would bring down a torrent of criticism on the Bank’s ahead. But if not this week then May, when the Bank will have the benefit of first quarter GDP figures as well as other data, is beginning to look like a racing certainty.