Bank of England Credibility Crisis?

Wrtten by Neil Patterson – Partner of The Money Centre, following his visit to a meeting at The National Skills Academy in Norwich for The Bank of England Quarterly Regional Inflation Report.

Do you think the Bank of England have lost credibility in dealing with the economy? That is an interesting question and one raised at the regional Quarterly Inflation Report by The Bank of England themselves.

Coming under recent heavy fire by the press for Inflation overshooting target for the last 5 years Mervyn King  asked them “what would you have done differently”.

The Bank of England committee is currently feeling a loss of credibility due to lower actual and expected output growth combined with a higher expectation for inflation, but is this fair?

Perhaps not. We have been through a period of externally generated inflation that has created a prolonged shock to the economy.

Oil prices have risen from $40 to $100 per barrel and Commodity prices have risen sharply with Cotton as the worst example rising by 140% since February 2010. This commodity price inflation has been fuelled by strong demand from emerging economies. 

Adding to this inflationary pressure Sterling has fallen in value against the Euro by around 25% since the start of 2007 making more costly goods even more expensive to buy from abroad.

The big question is will this externally generated inflation continue? The answer has to be that it will slow down.   This is because Sterling has stabilised now so that the exchange rate is no longer providing an upward pressure to the cost of goods and services. Commodity prices are set today taking into account supply and demand factors for the future hence we are paying now what the market thinks commodities will be valued at in the future.

If you think about it, at the current rate of inflation a litre of petrol will soon cost nearer to £3. This is highly unlikely though as market forces self regulate and demand would fall relative to supply thus depressing prices.

The Markets are however pricing interest rates 1% higher than the Bank of England and the Committee is split into 2 camps. Do they bow under to the pressure and save perceived credibility by tackling inflation with the only instrument they have (i.e. raise interest rates) or do they hold firm and try to avoid damaging the economy and fragile growth?

How does an increase in interest rates affect the cost of goods in the international market though?

Directly it doesn’t if you exclude exchange rates, so if the decision to act more strongly against inflation is taken we can only bear down on domestic inflation and slow our economy by an even greater ratio.

In case you are looking for an alternative solution any tightening of policy in the short term will be by interest rate rises and not the unwinding of Quantative Easing as this would involve the selling back of debt and currently the markets are just not strong enough to buy this back.

I could go into more detail, but what everyone really wants to know is, will interest rates rise?

The 2 – 3 year economic forecasts are now looking more pessimistic  and the honest answer is no one knows.  The Bank of England continue to look at their options on a month by month basis.

We are certainly in Interesting times.

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