Monday, February 21, 2011

What is the trigger rate for inflation?

At what rate of inflation would the monetary policy committee feel compelled to raise rates? It is certainly not four percent. We are there already and rates remain firmly fixed to the floor. Would it be five percent? Seven? Eleven?

There must be a number - a trigger inflation rate - where the MPC would finally act; a point where the costs of rapidly escalating prices are greater than any gains from protecting the banks and trying to revive the economy with cheap money.

Whatever the answer, the MPC have to deal with a rather unpleasant consequence of a near zero bank rate. The higher that trigger rate of inflation, the further the bank rate must travel before they can bear down on rising prices. If, say the inflation rate were cruising at a steady 7 percent a year, then a 25 basis point increase is unlikely to make much of a difference. The adjustment, if it is to be effective, is likely to be very nasty. There is always a cost for delaying the inevitable.

The crisis in the Middle East isn't giving any comfort to the MPC that it can avoid the trigger rate question. The oil price is swinging around violently with each political shock. Nevertheless, the trend seems unmistakable. Oil is at a two-year high. Today, Brent crude prices in London hit $105 a barrel today. If that price were sustained, then the Bank of England's central forecast of 5 percent will end up being a tad too optimistic.

It wouldn't be the first time that the Bank's optimism has led it to under-estimate external pressures on the CPI. Indeed, recent bank inflation forecasts have exhibited a strong bias towards under-predicting inflation. A cynic might suggest that these biases play a key role in rationalising the low interest rate policy stance of the MPC. The forecasts tell a pleasing story that lower inflation will eventually arrive, so long as everyone is prepared to wait out these recent external shock.

Instead of hoping for the best and pretending that inflationary pressures are temporary, the Bank needs to be looking closely at downside scenarios. For example, how would UK consumer prices react to political unrest in Saudi, with its inherent risks of disrupting oil supplies. What would happen to inflation if wage pressures in China were to increase?

Such scenarios cry out for a higher bank rate. They would also starkly illustrate that the magnitude of the interest rate adjustment will have to be large, thus exposing the MPC to the charge that it should have raised rates much sooner.

In fact, pushing rates down to zero was an over-reaction, largely driven by panic. It had a certain theatrical quality. The MPC acted like a magician, hoping to dazzle the audience with an unexpected trick.

With inflation now heading for five percent and possibly higher, the MPC might need to pull out their top hat and cape and prepare to play another trick with interest rates. How does a 300 basis point rate increase sound? Not shocking enough? Would 500 basis points be sufficient to have us gasping for breath?

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