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UK Interest Rates On Hold as Bank of England is Paralysed by Fear of Inflation

Thu, Jul 10 2008, 10:19 GMT
by Nadeem Walayat

Marketoracle.co.uk

The Bank of England Monetary Policy Committee is expected to keep interest rates on hold for a third month at 5% at today's meeting despite widespread calls for a rate cut in response to a collapsing housing market and an economy that is fast falling off the edge of a cliff, which is accompanied by more distress in the banking sector that saw Bradford and Bingley teetering on the brink of collapse earlier this week which resulted in the FSA leaning on the big UK banks to bailout the mortgage bank by agreeing to buy unsold stock at the rights issue price of 55p, against yesterdays close of 43p.

Why is the Bank of England Paralysed Into In-action ?

In one word INFLATION !

The call amongst industry and the city is for Interest rates to be CUT, but they WON'T due to surging food and fuel inflation that is being passed on down the chain to the consumers and hence resulting in inflation as measured by the CPI BUSTING through the Banks upper limit of 3% to presently stand at 3.3% and destined to march higher in the coming months towards 4%. Under these circumstances the Bank of England for at least the next 3 to 5 months is paralysed from acting in either direction for fear of either igniting a wage price spiral as workers demand higher wages to cope with the rising costs of living and hence employers passing on these costs to the consumer thus the spiral begins towards double digit inflation rates or tipping the economy into a deep dark recession on par with the early 1990's.

If the Bank of England succeeds in preventing the wage / price spiral from taking hold then the current inflation surge will prove temporary due to the deflationary impact of the continuing deleveraging of the $500 trillion derivatives market. Which is most evident in the inability of prospective borrowers to to obtain credit as the banks continue to announce ever larger losses and accompanying write downs with demands for cash injections either from the government, the market, or from cash rich sovereign wealth funds. Therefore this paves the way for deep cuts in UK interest rates starting mid 2009, however first the Bank of England needs to successfully steer the country through the current stagflationary environment.

However a spanner in the works is via the increasingly incompetent Gordon Brown Government which seems hell bent on pressing the electoral self destruct button. The government has lost its backbone and is seemingly incapable of saying NO to those that ride on the New Labour gravy train by agreeing to cash hand outs of several billions in order to try and buy votes. We have seen this in the May elections when the government gave away £3 billion ahead of the elections in response to the 10% tax band fiasco, and is likely to give away several billions more to placate vocal and rebellious public sector workers. The consequences of spending money that the government does not have is inflationary i.e. it completely undermines the Bank of England's strategy of keeping interest rates on hold to try get through the current inflation surge without triggering a wage price spiral. Well the government through its fiscal and spending policies IS fanning the flames of a wage price spiral.

The UK Is experiencing the perfect storm of DEFLATION as the housing bear market erodes home owner equity by several thousands of pounds every month, and INFLATION in the input and output prices surging to 20 year highs, therefore pushing the economy towards a Stagflationary recession during 2009.Whilst 2008 remains on target to achieve the Market Oracle forecast of 1.3% GDP growth for the year as of December 2007.

What the Bank of England Should Do!

The best strategy under current circumstances is for short sharp pain, meaning that the Bank of England should RAISE interest rates to send a signal to the Market and the workforce that any inflation busting pay rises will be countered by Interest Rate Hikes. This would have the twin effect of a. Lifting sterling and this reducing inflationary pressures on import prices and b. To nip stagflation in the bud, so as to ensure that the Bank of England is in control and ready to CUT interest rates following an earlier peak in inflation. Therefore eliminating some of the uncertainty of whether the Bank of England will be able to prevent the wage price spiral contributing towards a prolonged period of stagflation during 2009 which would prevent interest rate cuts as the BOE would be following events rather than creating the conditions for recovery.

Published on  Thu, Jul 10 2008, 10:21 GMT