Money
26 July 2010
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My former deputy and successor at the CBI, Andrew Sentance, who now sits on the MPC, has voted in each of the past two meetings to raise interest rates. He is essentially concerned about the risk of rising inflation.
On the other side, cebr has pioneered the view, now supported bymany other economists including, allegedly, MervynKing, that interest rates in the UK will stay low for a long time -at least to the end of 2011 and probably beyond.
We can't both be right...
Since Andrew is a good and serious economist, his views deserve to be debated in depth. This should be seen as a contribution tothat debate.
Under its remit, the MPC is targeted on inflation with a centraltarget of 2% for the CPI measure of inflation. Any rise in interest rates needs to be justified by a forecast of rising inflation. We do not think that this will happen.
We have always argued that the inflation outlook in the short term is highly uncertain. This is because the outcome -at least on a cost push basis -is a mix of the effects of strongly opposing forces. Keeping inflation up are rising oiland commodity prices, a weak pound and rising government indirect taxes and charges. Keeping inflation down are weak labour costs. Although labour costs are the only major downward influence, they are the single most important determinant of prices -in our model they drive 54% of the price level. On a demand pull basis our forecasts suggest that excess capacity, which pulls inflation down, is likely for at least the next 4 years.
Recently the data have reinforced our view that very low labour cost inflation is bedding in. Average weekly earnings growth excluding bonuses have been running below 2% (the MPC believes that the level consistent with inflation at 2% is as high as 4%) for over a year now and the latest data show a slight fall in the past two months. The trade weighted Sterling index has risen by 5.2% fromits low point in March, the dollar price of oil is still below the $80 that we assume for our forecasting and commodity prices in general (excluding cocoa for example) have been fairly weak.
We have, therefore, just produced a detailed monthly forecast for inflation based on our latest UK forecasts (attached overleaf) . This shows CPI inflation falling sharply from September this year, when we expect it to be 2.9%, to February 2011 when we expect it to be 2.2%. Thereafter we expect the forces acting in either direction to offset each other until early 2012 when the January 2011 rise in VAT drops out of the base. Combined with further falls we see CPI inflation reaching 1.6% in February 2012.
On this basis there is, therefore, no need to raise interest rates for at least the next 18 months.
This is good news, since if it beds into market expectations, I expect that the cost of borrowing to the consumer, which currently prices in future interest rate rises, should fall, particularly as the banks become better capitalised and more competitive. I would expect mortgage rates to be at least 70 basis points cheaper next spring.