imperalis finance

Written by Scott McEwan

On September 8th, to no one’s surprise, the Bank of England and Mervyn King’s Monetary Policy Committee decided to keep the base rate of interest at 0.5%. It was a unanimous decision made by the members of the committee.

The base rate has now been at this historic low since March 2009 when it fell from 1% and the Bank pumped up its asset purchasing scheme to £200 Billion. The Bank’s aims were to shimmy the consumer price index (CPI) up a touch in response to declining levels of consumer spending following the recession, wash the economy with a clean supply of money and try to tease out some lending from the banks.

However, the Bank received a mixed response following the move and not necessarily for the desired reasons. The CPI rebounded significantly and has been rising ever since. CPI now stands at 4.5%,increasing from 4.4% in June, well above the Bank’s target of 2%. The reasons for climbing inflation are certainly not of the overheating, demand-pullvariety expected from an economy with extraordinarily loose monetary conditions. In fact, the opposite is true. The Office for National Statistics believes the main determinant of rising inflation is the increasing of VAT, an in direct sales tax, from 17.5% to 20% at the start of the year and increasing global energy prices.

The Bank believes inflation will be back down to target level in two years but by what fortune is unclear. It is certainly possible that inflation could reach 5% before peaking, putting a significant strain on household budgets which will also have to contend with the government’s austerity plans. The Institute for Fiscal Studies says, over the past year, families have experienced the greatest fall in living standards in 30 years and the sapping of their spending power by the recession had been delayed rather than avoided. House prices too haven’t regained their previous stature, leaving households feeling much less wealthy. On the other hand rental prices have increased considerably because ofrising demand due to the difficulty for first time buyers to gain a mortgage.

However, since unemployment figures are scarcely improving-the UK jobless rate is now 7.9% and still increasing - inflation isn’t likely to be feeding into households’ wage demands amid the tribulations of the UK job market and the infrequency of businesses investing in the UK due to the frustrations of trying to get access to capital whilst contending with rising fuel costs.

Indeed, the economy does appear to have a significant degree of spare capacity. Gross Domestic Product is continually at the mercy of external factors and as result the recovery has had to gingerly contend with the likes of bad weather, natural disasters (Japanese earthquake) and one-off bank holidays (Royal Wedding). Economic growth in the 2nd quarter was a small 0.2%, but government leaders have been breathing sighs of relief whenever statistics show a positive growth number ever since a particular fierce winter in 2010 saw the economy contract by 0.5%. The UK economy has still not made up the ground to its standing before the financial crisis in 2006.

So what’s the Bank of England’s next move?There are some voices calling for the expansion of the Bank’s quantitive easing programme to provide even more stimulus at the risk of exciting inflation further. What is somewhat clear is that the economy would not take too kindly to both contractionary monetary and fiscal policy. The Government may consider taking VAT back down to 17.5% to go some way towards cooling inflation and putting a little more disposable income into the pockets of consumers. For the bank, hiking up interest rates too soon would provide reasons for the banks to push up the cost of loans while they are still thawing out and beginning to allow entrepreneurs to flex their animal spirits. Increase interest rates toolate and risk letting inflation spiral out of control completely. Timing is paramount. One thing is for sure, if inflation doesn’t abate soon, Mervyn King’s wrist is going to get awfully tired from writing all those letters to George Osbourne, the Chancellor of Exchequer, detailing why the above- target inflation is not entirely a consequence of the Bank’s policy.

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