Discussion and Analysis by Charles Porter:
BoE: Stop and Think – Please!
Part Two: To raise rates or not to raise rates:
To analyse the relationship between the two components of inflation, the dual graph below models the effect of food and services inflation respectively against overall price inflation. These graphs show that the source of inflation is most likely to be food (above), and thus import-led, inflation instead of an overheating domestic economy.
For the real economy over the medium-long term, this means that above target inflation is likely to be a fleeting phenomenon. This is a fact that Dr. Carney himself has recognised, but apparently supressed over his recent appearances. The more concerning spill-over of this reality is that an increase in interest rates will not improve the state of the economy, potentially inviting disinflationary pressures into the future and stunting economic growth. There was a reason that the markets had ‘underpriced’ the probability of an imminent rate hike; markets simply didn’t believe it was a credible or sensible policy option.
If the Bank of England chooses to raise interest rates during either of its November (2nd) or December (14th) Committee announcement dates, then money will still flow to the Pound, raising its value. But only in the short run. The positive effect upon the value of the Pound will be determined by other announcements and monetary policy progressions of, particularly, the FED and ECB.
The race to raise rates between the ECB and the BoE boils down to a first mover signalling advantage. The first hike will, artificially or credibly, signal to the international market that the domestic economy is healing and ready to accommodate a higher cost of borrowing and reward upon investment. However, the long-term effect upon the Pound Sterling could reveal that an imminent Bank Rate hike is a mistake, with no further hikes even throughout 2018 whilst economic growth and inflation struggle to prevail.
Ultimately, speaking as an individual citizen, short term Pound strength is far less valuable to me, than a more stable and long run recovery. Whilst forward guidance central banking may take a hit, the pragmatic policy decision at this time is a no-hike and to allow Brexit progress, genuine domestic inflation, and economic growth to manifest. Call me a Dove, but I hope markets can call Mark Carney one next month.