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Will the BoE raise interest rates after the latest inflation surprise?

12 September 2017

FE Trustnet asks analysts what the latest inflation figures mean for the Bank of England’s interest rates.

By Jonathan Jones,

Reporter, FE Trustnet

Analysts are split on whether the latest inflation figures mean the Bank of England (BoE) is more or less likely to raise interest rates.

Consumer Prices Index (CPI) monthly inflation rose to 2.9 per cent in August from 2.6 per cent last month, above expectations and matching May’s four-year high. Core prices were also up, rising to 2.7 per cent from 2.4 per cent in July.

Had inflation risen to 3 per cent Bank of England governor Mark Carney would have been required to write a letter to chancellor Phillip Hammond to explain why it had diverged so far from the target of 2 per cent.

CPI data since 1989

 

Source: Office for National Statistics

Retail Prices Index (RPI) data also rose to 3.9 per cent from 3.6 per cent, again above expectations, according to the Office for National Statistics.

The principal contributors to the increased rate were clothing and footwear, for which inflation was a record 4.6 per cent.

Ben Lord, manager of the M&G UK Inflation Linked Corporate fund, said: “Increased fuel prices were expected this month, but August is also a high inflation month given transport price hikes that take place as people head away for holidays, and as clothing and footwear prices are hiked with the new season’s collections coming to shop shelves.”

However, the big question following today’s confirmation of the jump in UK inflation data is how the BoE will respond.

Below FE Trustnet looks at whether the latest figures make the UK’s central bank more or less likely to raise interest rates to stem the tide of higher inflation.


 

Interest rate hikes are likely to come sooner rather than later

The latest inflation figures mean investors cannot dismiss the potential for an interest rate hike by the end of the year, according The Share Centre’s Richard Stone.

“The significant increase in the headline rate of inflation puts the Bank of England in a difficult position,” the chief executive said.

“On the one hand the governor will no doubt be relieved at not having to write to the chancellor at this stage. On the other hand it makes the interest rate decision more finely balanced.

“The Bank of England has been holding off raising rates despite growth having been ahead of expectations since the European Union (EU) referendum in June 2016 and despite rising inflation in large part due arising from the fall in sterling.”

Indeed, since the UK voted to leave the EU last year, sterling has fallen 11.06 per cent, though it has steadily risen throughout the course of 2017.

 

Source: FE Analytics

“A year on, that fall in sterling should have largely worked its way through the system and we can see this month inflation pressures coming from areas such as clothing not from typically dollar priced commodities such as oil,” Stone said.

“Rising inflation undoubtedly means that a point at which rates will rise is now closer. This may be compounded by the fact that the longer the Bank of England continues to hold off the relatively low rates help cause further weakness in sterling which in itself may drive yet higher inflation.

“A rate rise before the end of the year still cannot be ruled out, at the very least if the Bank of England decides it is necessary to signal the turning point in rates and that it will seek to address the rising inflation.”

Kathleen Brooks, research director at City Index, agreed that an interest rate hike could be sooner than many are expecting, with the BoE now more likely to raise rates before the European Central Bank (ECB).

“While a large percentage of these goods are imported and the price rise can still be attributed to 2016’s sharp decline in sterling, this is evidence that the consumer is coming under increasing pressure,” she said.

“If the BoE won’t step in to ease the pressure on the consumer now, then when will it?”

While she does not expect a rate rise to be on the cards for later this week, Brooks noted that there is a “rising chance” that the BoE may act before the ECB on hiking interest rates and normalising monetary policy.

This is for two reasons, she explained. The first is the currency, with the pound remaining weak while the euro has strengthened in recent months.

The second is that there are still some weaker areas in areas of the eurozone and the ECB does not want to stamp out its economic recovery. Meanwhile while the UK economy has been subdued, Brexit uncertainty hasn’t triggered a sharp economic downturn and business investment is still holding up well, she said.


 

The BoE will hold its course

Conversely, Ben Brettell, senior economist at Hargreaves Lansdown, believes the figures grant the BoE the freedom to continue down its path of keeping rates low.

“It looks likely that inflation will fall back in the coming months, as the effect of Brexit-induced sterling weakness falls out of the year-on-year calculation,” he said.

“Beyond the currency effect there appear to be few underlying inflationary pressures. Labour costs are the main factor in domestic inflation, and growth here remains below long-term averages.”

Demographics also need to be considered, he argued, with the baby boomers coming into retirement age and the generation behind them struggling to get on the housing ladder through burdening levels of debt.

“All in all I see more deflationary forces than inflationary in the world economy at present,” he said.

“All this means less pressure on the Bank of England to consider raising interest rates, and will allow the Monetary Policy Committee (MPC) to remove the sticking plaster of ultra-low interest rates as slowly as they like.”

M&G’s Lord agreed, noting that it seems likely we are now close to peak inflation.

“Given this, the MPC should look through any headlines this week and stay their course, given concerns around the outlook for the consumer, and enormous uncertainty about the post-March 2019 economy,” he said.

“If we are a month or so away from peak inflation, to hike rates, strengthen the pound and reduce breakevens would be overly myopic and pro-cyclical in my view.

“It seems likely that inflation and breakevens are going to start to slide back from here gradually anyway: why accelerate and exaggerate those moves by acting a month or two early?”

However, Lord added that there is the possibility that inflation does not recede, most probably though further sterling weakness on the back of Brexit negotiations.

“If inflation doesn’t fall back for whatever reason then the need to start bringing forward rate hikes and increasing their number intensifies,” he said.

Overall, Lloyds Bank Commercial Banking head of economics Adam Chester said Brexit remains the bigger driver for the BoE than inflation.

“On balance, we think that Brexit uncertainty will continue to trump inflation concerns, and rates will remain on hold for now – but the risks are shifting,” he said.

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