Inflation could be about to run out of control, spurring workers to demand higher wages to protect their living standards. A self-perpetuating spiral of higher wages leading to higher inflation is the fear that stalks all central banks. There is also a growing sense among some policymakers that the pandemic emergency is over, and so the emergency cut in interest rates from 0.75% in March 2020 should be reversed.
Does a bout of inflation always need to be dealt with?
The central bank’s monetary policy committee (MPC) has the task of keeping inflation at 2% over the medium term, which means the next two to three years. It can ride out a short burst of inflation, but more persistent price rises need to be tackled. The economy is almost back to the size it was before the pandemic and most businesses are operating with backlogs of work. Whether inflation will prove short lived remains unclear.
Why is inflation rising?
Shortages of raw materials, manufactured components and skilled staff in some industries have pushed up prices. From a rate of almost zero at the beginning of the year, the consumer prices index has risen to 3.2%, before falling back in September to 3.1%. The Bank’s chief economist, Huw Pill, says it is heading to 5% over the next few months. Until now the MPC has considered these trends to be transitory. It is possible the committee has changed its view and thinks inflation will persist.
Is the pandemic emergency over?
The government believes the emergency is over, which is why the furlough scheme has ended. But there are still plenty of measures in place to support businesses hit by the pandemic, indicating that Covid-19 is still dampening economic activity. Business investment is low, consumer confidence is declining and households are beginning to hoard savings again. Many people on middle and low incomes have suffered a financial shock from which they have not yet recovered. Some economists believe it would be a mistake that could even push the economy back into recession.
How can the MPC act?
The Bank’s main tool is to increase the cost of borrowing. A rise in interest rates dampens the amount of money people and businesses borrow. If less money is borrowed, there is less money to spend, bringing demand and supply more into equilibrium.
What kind of increase is likely?
Financial markets expect an increase of 0.15%, taking the base rate from 0.1% to 0.25%. Three members of the nine-member MPC are believed to be in favour of a rise and three firmly against. How the other three will vote, including the governor, Andrew Bailey, is not clear.
Does it affect mortgage rates?
Not always. Mortgage rates have been falling steadily through the pandemic. To win new business, lenders used the deposit savings built up by their customers to underwrite cheaper loans. That is likely to reverse if the bank base rate goes up, though possibly at a slower pace.
What if the Bank leaves rates unchanged?
Financial markets betting on a rate rise will be disappointed. Investors are likely to sell the pound, pushing down the value of the currency by as much as 10%. This will increase the cost of imports and could push up inflation next year when higher wholesale prices feed through to the shops.
