MPC members need to be sure of inflation risks before voting for rate rise

Martin Weale – the most-recently recruited external member of the Monetary Policy Committee (MPC) – writes in today’s Guardian to justify his call at this month’s MPC meeting for an immediate increase in UK interest rates. He argues that the longer inflation stays above its target level, and the further it is above that level, the more likely it is that there will be a permanent increase in inflation expectations in the UK.

This could cause higher inflation to become embedded in the economy. It would then be very difficult – and very expensive in terms of the damage to growth – to bring inflation back down to its target rate.

In other words, he is suggesting that ‘a stitch in time’ – in the form of a small rise in interest rates now – will ‘save nine’ – that is much greater interest rate hikes at some point in the future.

One problem with this argument is that we have a very poor understanding of how inflation expectations are formed. Surveys tell us that people expect higher inflation in 2011, but that is just a rational response to obvious inflation pressures – food and petrol prices, energy bills – and to talk in the media about higher inflation. On its own, it does not mean that medium-term inflation expectations have risen.

One of the most important transmission mechanisms by which higher inflation expectations feed through into a permanent increase in price inflation is through wages. This is what happened in the 1970s and again in the late 1980s – price and wages spiralling up together.

Why Martin Weale’s call for higher interest rates is surprising is that there is nothing to suggest such a wage-price spiral is developing in the UK. Wage inflation is stuck at close to 2 per cent. A weakening currency and increasing long-term interest rates (relative to those in other countries) would also be signs of higher inflation expectations. Again, these are absent.

Of course, monetary policymakers are paid not just to look at the latest data, but also to anticipate developments. Weale clearly judges the risk of higher wages or a loss of confidence in financial markets occurring during 2011 is sufficiently large to justify a pre-emptive strike now.

However, with unemployment at 2.5 million and set to increase as the public spending cuts start to bite, wage deals in the private sector are unlikely to be any higher in 2011 than in 2010. At the same time, there will be a partial pay freeze in the public sector, and tough settlements for those not affected by the freeze. Most people would think this makes any permanent increase in inflation in the UK most unlikely during 2011.

Given the damage higher interest rates could do to household and business confidence – at a time when the decline in GDP in the fourth quarter shows they are already very fragile – MPC members need to be very sure about the inflation risks before they vote for an increase.

Fortunately, for now a majority on the MPC appear not to be too worried about a permanent increase in inflation expectations. Let’s hope it stays that way in coming months.