How far will inflation and interest rates rise?

BoE

In February the US inflation rate as measured by the CPI hit 2.7%. In the UK the rate reached 2.3%. The US dollar had strengthened over the previous year, whilst the pound had weakened. Both economies were affected by rising oil and other commodity prices.

In the USA the arrival of higher inflation led to a 0.25% rise in official interest rates at the most recent Federal Reserve meeting. Markets expect at least another couple of 0.25% rises in rates this year, taking them up from the present 1.0% to 1.5%. In the UK the Monetary Policy Committee voted to keep rates at the ultra-low level of 0.25%. On both sides of the Atlantic the rate setters claimed there were balanced risks from here. In the US they argued they expected to keep inflation around their 2% target and would need further rate rises to do so. In the UK the Bank said it expected inflation to rise above target and to peak at around 2.75% early in 2018 before subsiding to target without rate rises. In the US one dissenter voted not to raise rates at all, and in the UK one dissenter voted to put rates up by 0.25%.

The Bank of England said it would not tighten despite the rise in inflation, because it thought the inflation overshoot here will be a temporary phenomenon which “entirely reflects the expected effects of the drop in the pound.” The US thought their inflation resulted from other causes and did need checking.

The UK rate of inflation went up in the year to February primarily thanks to the rise in the oil price and to a rise in rents and related housing costs. Transports costs, dominated by oil, contributed 35% of the rise in prices, and housing costs 26%. Restaurants and hotels added another 13%. Food, clothes, furniture and other retail goods were relatively stable in price over the year. The UK government has decided to alter the way it measures consumer inflation, switching from the traditional CPI to a new CPIH index which includes a proxy for the costs of owning your own house. It assumes an owner occupier has to pay a market rent for their property. This index mainly generated more inflation over the last two years, when rents have risen by more than general prices. The February figure of 2.3% was the same for both versions of the index.

The Bank’s view that inflation will just be driven by weak sterling is difficult to reconcile with the facts. UK inflation has risen similarly to US and German whilst sterling has fallen against both currencies. Dollar inflation has risen fastest despite dollar strength. It is true the UK is more dependent on imports, so it can be more influenced by currency and external trade. There may be more price rises to come from imports, though retail competition and world goods market competition has so far kept many prices down against a background of a sterling fall which started in the summer of 2015. In both the US and the UK the labour market has generated a lot of extra jobs, whilst there has also been substantial inward migration checking the labour shortages. UK policy is geared to try to get wages up, by introducing a higher Living Wage and urging business to hire more skilled people at higher rates of pay. Higher council taxes will also now figure in the new index, where councils are raising taxes to pay for extra social care.

It seems likely there will be more inflation in both the US and the UK. As the recoveries progress some wage growth is possible. Any further rises in world commodity prices will also have an impact. The Bank of England says it is expecting pay growth to remain modest, and for household spending to slow. If these assumptions are wrong the Bank will need to raise rates. If the Bank is lucky the oil price will subside under the weight of US shale output competing against the OPEC production cuts, removing the single biggest cause of the recent inflation upturn.

We assume with many in the markets that US and UK inflation will be a bit higher this year. The Fed is likely to put through another couple of rate rises. The UK Bank will come under pressure to make some start to raising rates in the UK, given that higher wages are part of government policy and given the ability of more businesses to pass on price rises as capacity is used up and as economic growth continues. Rates should remain below pre banking crash levels for some time, but the trend now seems to be upwards.


The above article by John Redwood, Charles Stanley’s global chief economist, was first published by Charles Stanley on 21st March 2017.