Expectations for interest rate rises as inflation hits 4%

Expectations for interest rate rises as inflation hits 4%

16 February 2011 / by Paul Dicken

The Governor of the Bank of England has insisted no decision has been made on future interest rises and the Monetary Policy Committee ‘clearly haven’t’ decided that rates will go up.

Presenting the Bank’s inflation report on 16 February, Mervyn King said people would be ‘running ahead of themselves’ by putting a date on rate rises. He said the MPC didn’t play the ‘game’ of taking a decision in private then ‘hinting where rates will go’.

In the open letter to the Chancellor to explain why inflation was above the two per cent target, Mervyn King told George Osborne that: “The MPC’s [Monetary Policy Committee] central judgement, under the assumption that Bank Rate increases in line with market expectations, remains that, as the temporary effects of the factors...wane, inflation will fall back so that it is about as likely to be above the target as below it in two to three years ahead.”

He also reiterated the position that the committee judges any attempt to bring inflation down too quickly risk creating volatility and a situation where inflation drops below two per cent further down the line.

Referring to ‘market expectations’ on changes to the Bank Rate, which is also known as the official interest rate, and affects the rates on bank deposits and mortgages, prompted many commentators to suggest the Bank Rate could rise slightly in May, and end the year at one per cent.

However, King told a press conference that judgements on the timing of a rate increase were difficult and decisions were made month by month based on the facts at hand.

Reaction in financial markets

Co-manager of the M&G UK Inflation Linked Corporate Bond Fund, Ben Lord, said the market reaction to the inflation figures had been subdued because the numbers and anticipated rate hikes are largely priced into the market levels.

“In a more normal environment where you see RPI [Retail Prices Index] coming in above 5% and CPI [Consumer Prices Index] above four per cent you would expect conventional gilts to start selling off, as people expect higher interest rates introduced to control inflation.

“However, the gilt yield curve has so far moved very little – this isn’t the market moving in anticipation of a 25 or even 50 basis point hike in the next couple of months, but a reasonable controlled reaction.”

Lord said the current low Bank Rate was preventing ‘a serious step back’ for the economy because rate increases would increase the cost of borrowing and impact on demand.

"I am fearful of the effect of interest rate hikes on a very over-borrowed economy and particularly an over-borrowed consumer. You only have to look at real wage growth which is negative at the moment. The consumer is getting poorer and if there's an interest rate rise we'll be entering a variable rate borrowed economy meaning even more of a hit to a consumer that's already feeling the pain," he added.

Inflation report

In its inflation report, the Bank of England said CPI inflation was likely to pick up to between four and five per cent and remain above target ‘over the next year or so’. This is largely reflecting the much trailed impact of the VAT increase introduced at the beginning of the year.

Concerns over the strength of the economic recovery persist, which raises the risk of inflation dropping below target over a longer term horizon and in King’s letter to Osborne he said the MPC was ‘conscious that there are large risks in both directions’.

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