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Economics Weekly: Beware, inflation expectations can cause interest rate rises

August was a month of central bank meetings
The August rise in the UK’s official base rate was a surprise only in its timing; the actual rise was well anticipated by the financial markets. Interestingly, the last time UK interest rates were changed was in August 2005 and the time before that in August 2004. However, this latest move seems unlikely to be the last shift in the next twelve months. Last year’s cut in UK interest rates seems to have been a mistake, as the economic recovery was already underway according to the data for gdp. Now, one rise seems unlikely to be enough to keep inflation on track to meet the 2% target in two years time. The US monetary authorities, the Fed, may have made a mistake with the decision to keep rates on hold. Only time will tell, but in both the UK and the US inflation expectations seem high enough to suggest that actual inflation may rise further, putting official interest rates under upward pressure. In the EU, interest rates were raised by the European central bank, the ECB, as expected, with more in the offing. We concentrate on US and UK policy issues in this economic brief.

Inflation expectations affect actual inflation rates
One of the key drivers of future inflation is expectations, in the financial markets or amongst business and consumers. The Bank of England discussed in the August Inflation Report how relatively low inflation expectations in the UK over the last few years may have acted to help keep down ‘core’ inflation and so wage inflation and overall price pressure in the UK at a time when headline price inflation had accelerated. The implication was that keeping a lid on inflation expectations, by ensuring that domestic firms and workers believe that the central bank will act to keep inflation on its 2% target, is something that the central bank thinks is crucial in helping it to meet its target of stable inflation in the medium term. The close link in the UK between inflation expectations and the rate of actual price inflation is shown in chart a.

US central bank risks being 'behind the curve'
Expectations is something that the US central bank has also mentioned many times in its recent speeches. In the latest statement following the August decision to keep rates on hold it said that: ‘inflation expectations are contained”. We would dispute that last comment. As chart b, shows US inflation expectations, as measured by the break even inflation rate, the difference between nominal bond yields and the inflation protected rate, have actually risen quite markedly this year. Hence, the US central bank stands to lose credibility if its belief that a slowdown in economic growth will be sufficient to lead to a fall in inflation is not borne out by events. This is especially important since, as chart c shows, the reason why US inflation expectations have risen is down to a sustained and sharp rise in core (ex energy & food) inflation over the last 3 years, including over the last year. This seems to suggest that US economic growth will have to slow to a below trend pace (roughly 3%-3.5% a year) in the next few months, sufficient to lead inflation lower. The danger is that though the US economy may slow, the slowdown is not deep enough to push inflation lower and so the central bank will lose credibility. The result will be that it will have to raise interest rates by more than it would otherwise.

UK inflation rate to head higher, so interest rates are likely to be raised by November
The latter is very important, as UK inflation expectations as measured by the monthly Lloyds TSB Corporate Markets Consumer Barometer shows. It correlates very well with the official measure of UK consumer price inflation, and with the Bank of England’s NOP survey measure, which is also suggesting that inflation expectations remain above 2%. This is one reason why the Bank of England may have taken the decision to raise interest rates in August. There was a real risk that it would lose credibility if inflation continued to rise further about the 2% target and it did nothing to try and correct it. Chart d shows the extent to which UK price inflation has already risen above the 2% medium term target. Our calculations show that the effects of the rise in gas and electricity charges planned for September and the rise in university tuition fees in October will take annual consumer price inflation to 3% in November, which will be close to prompting an open letter from the Governor of the Bank of England to the Chancellor stating why this had happened and what he was doing to bring it back towards its medium term target.

The Bank of England’s own inflation forecast, based on 4.75% interest rate, shows that inflation would fall back towards, but still be above, the target in 2 year’s time, see chart e. This suggests to us that a rise in base rates to 5% in November is almost a done deal. Only significant signs of better than expected inflation or slower economic growth would prevent this rise taking place. But the Bank has revised up its estimate of UK growth since the last Inflation Report in May, see chart f. A view that official interest rates will have to be raised further is now priced into the UK money markets. The short sterling futures contract, which looks at where base rates may be in future, suggests that there will be one, and possibly two, more base rate increases over the next year or so. There may be a lesson for the Fed from all of this. If its assumption that inflation falls back does not happen, then it risks a further rise in inflation expectations and then having to raise interest rates further, perhaps by more than if it had acted sooner.

Trevor Williams, Chief Economist
trevor.williams@lloydstsb.co.uk
www.lloydstsbfinancialmarkets.com
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