A small rise in interest rates now would cost us less in the long run than higher ingrained inflation
As we cast our votes at the January meeting of the Bank of England's monetary policy committee ? ahead of last week's GDP figures ? I saw a compelling case for an increase in the bank rate. My concern is that, if businesses and pay-bargainers come to regard an inflation rate of 3%-4% as normal, it will become more costly for the MPC to keep inflation close to the government's 2% target. The longer inflation stays above the target and the further it rises, the greater the risk that inflationary expectations will become built in.
Much of the increase in inflation has been a consequence of sterling's depreciation, sharply rising commodity prices, and increased VAT. It has not been generated by rises in domestic costs. Sterling's exchange rate has been fairly stable for some time and the effect of the most recent VAT increase will pass out of the inflation figures in 12 months' time. Given the potential consequences for the economy of trying to return inflation to the target rapidly, there is a powerful argument that such "one-off" influences on the inflation rate should simply be accommodated, and inflation allowed to rise temporarily above the target. This is consistent with the MPC's mandate.
The trouble is that only with hindsight can one judge how far some of these effects are truly "one-off". There is a risk that continuing rapid economic development in China and elsewhere will lead to persistent upward pressure on commodity prices. And even if that does not happen, there remains a risk that inflationary expectations become ingrained as a result of continued high inflation, whatever its cause.
These arguments make a powerful case for a modest rise in the bank rate ? not because it should or would reduce inflation immediately (it would not), but because it would reduce the chance of high-inflation expectations becoming ingrained. The costs of a small rise now would be lower than the eventual price of addressing higher ingrained inflation.
However, the most recent GDP data shows the economy appreciably weaker than expected. Without the effects of bad weather it is estimated output would have stagnated late last year. This is alarming ? a faltering economic recovery implies human misery and a waste of resources ? but not surprising. All recoveries from recessions since the first world war have been uneven, although in only two (1930-33 and 1973-76) was there a clear "double dip". If growth resumes shortly, my concerns about inflationary expectations would remain. But were the recent weakness to mark the start of a sustained new downturn, inflationary pressures would be likely to fade without a bank rate increase.
This dilemma illustrates the problem policy-makers face. Economic policy needs to respond to the facts; to ignore them would be absurd. But how much weight should be placed on the most recent data, which may be erratic and subject to revision? Too great an emphasis on the latest numbers creates the risk of policy movements that are erratic and inappropriate. But placing too little weight risks falling behind the curve, which could be even more detrimental to economic prosperity.
The natural response to that dilemma is pragmatic: monetary policy must be made, month by month, based on a judgment about the balance of risks and how they have evolved. A major risk is that the longer inflation remains above target and the more it exceeds its target, the greater the adverse effects on output of bringing it down. Each month's MPC decision needs to be made on its own merits, but this risk is a substantial one that I will continue to balance against others over the coming months.
Source: http://www.guardian.co.uk/commentisfree/2011/jan/30/interest-rates-rise-ingrained-inflation
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