Looking through inflation: the Base Rate dilemma

Since the main job of the Bank of England’s Monetary Policy Committee to control inflation it was quite refreshing to find inflation back at the centre of discussions in minutes of the October meeting.

After all these months of unemployment and latterly “slack” we’ve heard so much about, it was a welcome note of familiarity.

The debate seems to boil down to one key question: how far is it appropriate to “look through” the current low inflation figures? To what extent is the shock drop in inflation down to temporary, external, or otherwise “artificial” factors that can legitimately be disregarded (at least for now), and how much is due to our being in, to use the technical phrase, a bit of a pickle?

The minutes present it like this: most members of the committee took the view that, “While it was appropriate for policy to look through the near-term effects of lower import prices ... CPI inflation had fallen relative to an already weak outlook ... there remained few signs of inflationary pressure in the UK economy.” Then going on to cite weak pay growth, weak Eurozone, weakening housing market etc as causes for concern.

In other words, the current weak inflation is symptomatic of the deeper malaise, it’s not going to go away on its own, and so we need to pay attention to it.

On the other hand, the two dissenting voices looking to increase base rate felt, “Just as the Committee had looked through the first-round effects of external price pressures when they had pushed inflation up, it was appropriate to look through them at present when they were pushing inflation down..... Since monetary policy could be expected to operate only with a lag, it was desirable to anticipate labour market pressures by raising Bank Rate in advance of them.”

The reference to earlier, higher inflation concerns is interesting. Surely everyone remembers the regular exchange of letters between Governor and Chancellor because inflation was running far too high - or if not that precisely, the spiralling food, petrol and utility bills – with many criticising the MPC for taking no action (ie. not raising Base Rate).

At the time the Committee argued high inflation was caused by short-term and external factors (rising oil prices, mainly) which

a) moving the base rate could do nothing to fix and b) did not reflect the underlying domestic situation

This is the argument Martin Weale and Ian McCafferty are using now from the opposite corner: that the official inflation rate is artificially low and the underlying situation is much stronger, so we should look through this blip to the core picture.

Otherwise, they argue, once the inflationary touch-paper catches, it’ll go off like a rocket and the chances of controlling that with small, gradual measures are pretty slim.

The difficulty facing the MPC is rarely shown more clearly: on one hand risk accelerating inflation needing drastic interest rate hikes, on the other moving early and risk derailing what’s still a very fragile recovery. And the only thing to decide between the two is one’s personal judgement of which way we’re drifting. Sometimes I wonder if they get any sleep at all.

 

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