Inflation Worries in England
An inflation rate nudging above target and flirtings with space capacity in the economy suggest that the Bank of England will continue to raise borrowing costs.
Applying the test that turkeys rarely vote for an early Christmas, comments yesterday by the trade body representing estate agents were telling. A pre-emptive rise in interest rates would keep inflation in check, said Milan Khatri, chief economist at the Royal Institution of Chartered Surveyors. "The Bank of England would be well advised to act this week."
The City expects the nine members of the Bank's monetary policy committee (MPC) to heed this advice when they gather today for a meeting that will culminate in tomorrow's decision. Mervyn King, the Bank's governor, insisted last week that there were "no done deals" on the MPC. But if even estate agents think borrowing costs are a tad low, it would be a shock were the base rate not to rise by a quarter-point to 5%.
A number of factors concern the Bank. The first is that inflation - as measured by the Consumer Prices Index - stands at 2.4% and is thus above Mr Brown's 2% target. On its own, that would not be a big concern, because interest-rate decisions are based on where inflation is likely to be two years in the future, not where it is today.
What worries the MPC in the short term is that there appears to be little spare capacity in the economy. Growth has picked up, the stock market has returned to levels not seen since the dotcom boom, the housing market is strong and the service sector is upbeat.
In the longer term, Mr King thinks that the days when Britain could use the forces of globalisation to import low inflation may be coming to an end. The Nice (non-inflationary constant expansion) decade is giving way to the not-so-Nice decade, he fears. Strong growth in countries such as China has pushed up commodity prices, raising the cost of energy in Britain and making imported manufactured goods more expensive for wholesalers. The governor fears that the first-round effects of dearer imports will lead to more serious second-round effects on wage deals and shop prices.
Not everybody views tomorrow's decision as a foregone conclusion. Andrew Smith, chief economist at KPMG, said: "While the case for a hike appears pretty conclusive ... there is still little evidence of the feared second-round effects actually coming through to support them. The recent deterioration in the international outlook, with the abrupt slowdown in the US economy, may give some members pause for thought."
Also The Economist has an article on the inflation scare in England (bold citations are my emphasis) and cites the quarterly inflation report from the Central Bank. Given the lagged effect from interest rates on the economy (also called the monetary transmission mechanism) rates are needed today to bring inflation under the 2% threshold (currently running at about 2.4%) by mid 2008. Note also how the surge in immigration is linked to fluctuations in potential output.
Economic developments over the past three months have not shaken the case for a further rate rise. The economy grew by 0.7% in the third quarter, leaving GDP 2.8% higher than in the same period in 2005. More important, inflation remains stubbornly above the target. Despite the recent fall in oil prices, annual consumer-price inflation has eased only marginally, from 2.5% in August to 2.4% in September. Measured by the broader retail-price index, which still features in many pay negotiations, inflation picked up from 3.4% to 3.6%, the highest for over eight years.
The familiar reason is the housing market. In 2005 residential sales wilted and prices went nowhere. But the market has sprung back into life. House prices rose by 8% in the year to October, according to the Nationwide building society. New mortgage approvals for buying homes were unexpectedly strong in September, rising from 120,000 in August to 126,000, the highest since February 2004.
For some time the bank has wanted the economy to become less reliant on spending by consumers and the government—the twin engines of growth for most of the past decade—and to get more thrust from investment and exports. After a long period of surprisingly weak growth, business investment is at last picking up. Firms are also being helped by demand from the reviving euro area, which buys about half of British exports. The American slowdown may be less helpful for exporters. All the same, resurgent consumer spending could still pep up overall demand too much.
Just how big an impact higher immigration is having on potential output goes to the heart of the rate-setters' dilemma. On the face of it, there has been a spectacular expansion in the workforce since 2004. Around half a million migrants from eastern Europe have started working in Britain over the past two years. Thanks also to the return of older people to work, the labour force has been growing at its fastest rate for more than 20 years.This suggests that the bank should be pushing up its estimate of potential output. The migration figures are notoriously poor and difficult to interpret, however. For example, some of the newcomers from eastern Europe have returned home, yet timely estimates of this outflow are not available.