Interest rates: where now for Government’s Plan B?

Whichever way you slice it, inflation is back. CPI, RPI, month-on- month at a record, and even core inflation too. It will take X-ray vision to attempt to “see through” this rise, and thus basically ignore it.

The Consumer Price Index was well above expectations at 3.7% in December, and almost double the Bank of England’s target rate of 2%.

Inflation on the CPI measure is almost certain to surge above 4% by February.

Of course this will come as little surprise to anyone filling up a petrol tank, or at a grocery checkout or paying for their gas bill. 

Commodity prices from wheat to cotton to crude oil have been on the rise, and this is partly due to the super-lax monetary policies employed in the US and, yes, the UK as well as I discussed in my blog on Tunisia on Friday.

So yes it is true to say that the inflation is generated in global markets, so what might be the point of an early rate rise? Well there is some evidence that the public is beginning to factor high inflation into domestic expectations. In turn, some companies are anecdotally reporting rising wage pressures. The first figures on this will be out next week.

My expectation is that the Bank of England is starting to turn the tanker around on monetary policy. This will not necessarily be a rapid process. But I think it will start earlier than many appreciate. In a recent FT survey, half of City economists questioned whether the Bank was ignoring its inflation target. FT lead comment pieces openly state that the Bank has parked its inflation target. Understandably, there certainly seems to be quite some attention paid to Nominal GDP growth, a measure which includes inflation and growth.

At the Bank they flatly deny any backsliding on the inflation target, but they will also recognise that the genie may be seeping out of small cracks in the bottle. As MPC member Andrew Sentance told me last month acting decisively now, will lessen the pain of even higher rate rises in years to come. A small rise now will merely be taking the foot slightly off the accelerator rather than slamming on the breaks.

I expect one toe-dipping rise in the first half of the year. I then expect the announcement of a programme of bond sales to unwind QE, what I have previously called “quantitative tightening” or QT – which could raise longer term interest rates too. Rate rises in earnest, will probably occur from Autumn. Of course it all depends on the balance of arguments within the MPC, but my basic analysis is that they are far closer to this than is commonly realised.

This creates a monster headache for the Government. As taxes have gone up, and spending is being cut, the Treasury and the Prime Minister have been under pressure to outline a “Plan B”.

The PM responded by saying he was a “fiscal conservative but a monetary activist”. The implication: that if the economy slowed sharply, Mervyn King could just print more money.

It was an analysis pushed by rightish think-tanks such as Policy Exchange and the IoD (Institute of Direcotors). The inflation numbers, the rise in expectations, and the open questions about anti-inflation credibility mean that this is now very difficult.

And for sceptical voters facing lighter pay packets, rising unemployment, and rising prices, there is the prospect of higher borrowing costs too.