In particular, it is highly unusual for the MPC to act ahead of an “Inflation Report” month, the next one being in February. Therefore, something must have happened to make the Committee expect inflation to now diverge significantly away from the profile set out in November, which showed the annual rate of change in consumer prices moving back down to the 2% target by mid-2007. Rumour has it that higher petrol prices (in part due to Gordon Brown’s fuel duty increase) will have caused inflation to spike up to more than 3% in December, compelling the Committee to write a letter of explanation to the Chancellor. This in itself wouldn’t be a problem provided the MPC could convince itself that inflation will subsequently fall back again in January – indeed, to this end, petrol price effects should work in the opposite direction this month. Unfortunately, the MPC is concerned that the recently announced increases in rail fares mean that this won’t happen, causing inflation to be at its highest just as we enter the main pay round.
The problem with the MPC raising rates now, however, is that this will directly push up inflation as measured by the Retail Prices Index (from 3.9% in November to perhaps 4.3% this month), and it is the RPI annual rate that tends to have the largest bearing on pay settlements. But even more fundamental than this, what we again appear to be witnessing is monetary policy being used to curb increases in “non-market” prices – how can higher interest rates counter higher rail fares or petrol prices? Yes, spending on the High Street has not collapsed during the course of 2006, but this is only because retailers have been forced into further cuts (yes cuts) in prices. We do not question that the cost of living has increased significantly over the last 12 months, but what we would strongly challenge is the notion that this has anything to do with overheating domestic economic conditions and instead has everything to do with administered price increases in areas of the market place that are protected from competitive pressures.
We would also challenge the MPC’s judgement that there is no spare capacity in the UK economy. We accept that growth has been above trend in each of the last four quarters, but at 0.7% only very marginally so, whilst in the previous five quarters growth was significantly beneath trend. Consequently, providing growth remains close to trend, or even slightly beneath it over the coming few quarters, it follows that the UK economy will be operating beneath its productive potential throughout all of 2007 and into 2008. We therefore continue to believe that inflationary pressures will ease over the course of the year. By further raising debt servicing costs, which have already risen sharply over the last 18-months as a result of record personal sector indebtedness, today’s increase in interest rates clearly increases the risk of a sharper deceleration in economic activity this year than we have been predicting – our forecast is growth of 2.4% this year compared with 3% for the Bank of England and the Treasury. However, on a positive note, it also increases the chances of lower interest rates before the end of the year.