Wage Inflation Is The Key To Further UK Rate Cuts – by Lloyds TSB (Forex)

UK price inflation is heading back up again, yet the central bank has cut interest rates twice in three months. How can it justify this when its inflation target is 2% and the actual rate of inflation is above this level and likely to rise even further in the months ahead? The answer, of course, is that the central bank is looking for economic growth to slow such that inflation falls in the medium term.

Can wage inflation stay low if price inflation accelerates?

 

UK price inflation is heading back up again, yet the central bank has cut interest rates twice in three months. How can it justify this when its inflation target is 2% and the actual rate of inflation is above this level and likely to rise even further in the months ahead? The answer, of course, is that the central bank is looking for economic growth to slow such that inflation falls in the medium term.

 

The Monetary Policy Committee (MPC) noted in the minutes of the February meeting that ‘the central projection suggested that there was most likely to be some spare capacity in the economy, even if interest rates followed the path implied by market yields. That would therefore help to ensure that inflation returned to the 2% target in the medium term’. This is illustrated in chart a, which assumed Bank rate would be cut to 4.5% in 2008 and stay there and that UK economic growth falls to well below 2% by the middle of 2008 before recovering back to trend in 2009.

 

But the MPC was still very worried about inflation and also said in the February minutes: ‘the Committee expected that higher energy and food prices would raise inflation, possibly quite sharply, in the coming months. Producer input and output prices were already rising rapidly and the decline in the sterling ERI would boost import costs further.’

 

Further, the MPC went on to say that: ‘measures of inflation expectations had not fallen in line with actual CPI inflation following its peak during 2007. There was a risk that above-target CPI inflation in the near term would affect inflation expectations, and hence have some tendency to persist in the medium term.’ The MPC is clearly
worried therefore that the rise in price inflation will feed through into wage inflation and so into widespread inflation pressure in the economy as a whole, which would be very costly to reverse.

 

 

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