Inflationary Environment

The big news in the UK yesterday was the Office of National Statistics releasing the CPI figures for march (ONS news release(pdf)). CPI was at 3.1%, a figure that resulted in shock across the markets – it was widely expected that inflation had peaked at 3.0% earlier this year. As per the arrangements with the government, any month in which inflation is more than 1% out from the 2% target, the governor of the Bank of England must send a letter explaing to the chancellor why (Mervyn’s Letter(pdf)). This was followed by a response from the chancellor Gordon Brown (Gordon’s Response(pdf)). Both letters are quite illuminating, and worth a read.

Of course, such high inflation figures are more likely to result in interest rate rises sooner rather than later (Rake hike fear). Currency markets have already reacted to the news, pushing “cable” (USD/GBP) through the £1=$2 barrier today. As the US economy looks increasingly weak, I expect this to continue in the short term. however, in the medium to long term, It’s quite possible that economic weakness will spread across the Atlantic, resulting in continued inflation but with stagnation of the economy. As the deflationary effects of cheap Chinese consumables and fixed currency markets unwinds (Evan Davis: iIs the China effect over?), the markets may put the Bank of England in between a rock and a hard place: Inflate or Stagnate?

I do find it a little odd that the government gives the Bank of England the power of modifying interest rates, and expects it to control inflation. Surely there are many more factors influencing the rate of inflation – and the Bank gets blamed for any problem! Policies inacted by the Treasury will certainly effect the going rate of inflation, but are not under the control of the Bank. To me, this system has been ridden by the current government which takes credit for the stability of the economy over the last few years, while insulating it from any blame. It’s a win-win policy for the government!

Whatever the causes of the inflation statistics, one thing does seem clear. We’ve had a long period of low interest rates, with stable economy and resilient growth. That’s not likely to continue. Volatility in the markets is up, growth tepid, and inflation rises, most likely leading to higher interest rates. Interesting (no pun intended) times indeed.