HIGHER interest rates are on the way: that is the lesson from this morning’s strong January retail sales survey, the latest of a batch of statistics suggesting the economy bounced back in January. Even before today, markets were already pricing in a 100 per cent chance of a 0.25 per cent rate hike in May, with short-dated swaps attributing a 20 per cent chance of a hike on Thursday. We shall soon find out.
I regularly encounter two related objections to raising the Bank of England’s short-term rates from their current, ridiculously low 0.5 per cent. Many argue that our elevated rates of inflation come either from higher tax or from higher commodity prices – and therefore are either not “real” or are out of the Bank’s control. Let’s take these points in turn.
CPI-CT and CPIY, which supposedly strip out the effect of tax, are running at just 1.9 per cent and two per cent. But these esoteric measures are calculated on the assumption that indirect tax hikes are passed on in full to consumers. This is nonsense. Pass-through was only one-third after the 2008 VAT cut. Assuming that one-half of the increase in indirect taxes last year was reflected in the prices charged to consumers, Henderson calculates that inflation would now be 2.8 per cent had tax rates remained stable – still too high.
What about commodities? UK inflation is much higher than elsewhere, even though most countries are facing the same supply shock (dubbed cost-push inflation by some). The reason why the Bank is tasked with keeping inflation at around two per cent a year is that it has much greater powers over average prices than many people realise. It can’t stop individual prices – such as wheat – from shooting up – or others– such as the cost of computers – from collapsing. But it has a huge influence over the average price in the economy.
This is because it can vary the total amount of demand in the economy; in turn, this is because it can largely determine the overall amount of money. That is why Milton Friedman said that inflation is always a monetary phenomenon: he meant that it is always in the power of the central bank to create or to stop inflation using its control of the printing press, short-term interest rates (and in some countries) its powers to force banks to hold more or less capital.
Higher commodity prices don’t automatically lead to increases in the overall, average price level: this only happens if the Bank of England doesn’t adjust demand to compensate. Regardless of oil and commodity prices, a disastrous bout of deflation could be generated in a matter of months were the Bank to suddenly sell tens of billions of pounds worth of gilts, sucking out pounds from the economy and slashing aggregate demand. Alternatively, the Bank could trigger hyperinflation by crediting every single bank account in the country with an extra £100,000 – as consumers rush out to buy goods, services and assets, prices would jump almost instantaneously. Manipulating “demand-pull” forces can cancel out “cost-push” pressures – the claim that the Bank can’t control inflation in the current climate doesn’t stand up to scrutiny. Those who don’t want higher rates should be arguing for the Bank’s target to be scrapped – not claiming that it has no power over inflation.
Ultimately, all of this is academic. Interest rates are going up, and rightly so. It is just a matter of when, not if.
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