Another week, another reason for the Bank of England not to raise interest rates.
The latest is the surge in gas prices. These have quadrupled since February, and will lead to Ofgem raising the energy price cap for retail customers by 12 per cent next month. That alone will add 0.4 per cent to the CPI, and many customers will face even bigger rises as the low-cost tariffs offered by now-defunct suppliers disappear.
But shouldn’t higher inflation mean higher interest rates?
Not in this case. Higher energy prices raise the cost of doing business and so reduce output and raise unemployment. Higher interest rates have the same effect, so they just magnify the problem. This is recognised in the Bank of England’s remit, written by the Chancellor each year. It says that, when faced with “shocks and disturbances” an attempt to keep inflation on its 2 per cent target “may cause undesirable volatility in output.” In such cases, wrote Mr Sunak, the Bank “may therefore wish to allow inflation to deviate from the target temporarily.” Higher gas prices are one such shock.
We can put this another way. The only way in which higher interest rates would reduce gas prices would be by raising firms’ costs and so reducing demand for gas. They would do nothing to improve energy supply. In fact, they might worsen the problem because a higher cost of capital would – at the margin – reduce investment in greener or energy-efficient technologies.
The best thing the Bank can do about higher gas prices is therefore nothing.
Which poses the question: in which circumstances should the Bank raise rates? One would be if inflation looks like rising sustainably above two per cent because of strong aggregate demand. We’re some way from that point: unemployment is still above pre-pandemic levels, and total hours worked well below them. This suggests demand is still weak in aggregate, and that inflation is the result of localised shortages and mismatches between supply and demand.
There is, though, another condition. A rate rise would be needed if inflation expectations are high and rising: this is because such expectations can be self-fulfilling and hence a way in which higher inflation can become entrenched.
Evidence here is mixed. Households expect inflation to fall. A recent survey by the Bank found that people believe the inflation rate is now 2.9 per cent, but expect it to fall to 2.7 per cent in 12 months’ time and 2.2 per cent in the following 12 months. These numbers are however higher than three months ago.
The gilt market, though, is a little worried. Five-year conventional gilts now yield 3.6 percentage points more than index-linked ones. Even allowing for a gap between retail and consumer price inflation and for an inflation risk premium, this suggests the market expects consumer price inflation to exceed its 2 per cent target on average.
For now, these numbers are not alarming: the gilt market’s inflation expectations are no higher than they were in early June. Any further increase would, however, suggest that people are losing confidence in the Bank’s ability or willingness to keep inflation at its two per cent target. A big reason why two MPC members (Dave Ramsden and Michael Saunders) recently voted to curb QE was precisely to ensure “that medium-term inflation expectations remained well anchored.” If they don’t remain so, rates will rise.
