Bank of England holds interest rates again

There has been increasing speculation that the MPC would increase interest rates, with the majority in favour of holding them becoming smaller in recent months.

In particular, the rate of inflation has consistently overshot expectations in recent months and the latest figure for CPI was 4.4% compared to the MPC's target of 2%. By refusing to do anything the MPC has been accused of a dereliction of duty and has lost some credibility as inflation has steadily risen. Moreover, the Committee has been forced to play catch-up with its own inflation forecasts, giving the impression that it is always behind the curve.

The hawks on the MPC have increasingly expressed their concern about the negative effects that higher inflation can have on the stable management of the economy. Two members, Spencer Dale and Martin Weale, have cited rising inflationary expectations as a reason to impose a tighter monetary policy sooner rather than later. Indeed, recent surveys have pointed to higher expectations and the danger is that once entrenched they can be very difficult to reverse.

The doves, however, point out that the gilt market remains relatively relaxed about the threat of inflation. The implied rate of expected inflation in the gilt market has remained steady at 3.1-3.3% for some time while the level of reported inflation has been rising sharply. This partly reflects a lack of pressure for higher wages due to rising unemployment and the curbing of trade union power, as well continuing spare capacity. However, Ted Scott, Director, Global Strategy at F&C, believes the main reason is the transient factors that the Governor, Mervyn King, has referred to in every letter he is forced to write to the Chancellor, and the recent weakness of the economy.

Scott commented: "On the first point, the large spike in commodity prices, especially oil, has added to reported inflation and is outside the MPC's control. In addition, the weakness of sterling over the last year and indirect tax increases are cited as reasons as to why inflation should fall back. On the latter, it is estimated CPI would be about 2.7% rather than 4.4% without the tax increases."

In Scott's view, the recent weakness of the economy was probably the decisive factor in determining that rates should remain static. The last quarter of 2010 saw growth of -0.5%, well below forecasts, and since then there has been more evidence that the consumer is reluctant to spend. Consumer confidence has plunged recently just as austerity measures are beginning to bite, and the MPC will likely not want to jeopardise the economy any further.

"Given the unusually tough economic environment - especially for the consumer, which is the lion's share of the economy - I believe that the Committee is correct to stand pat. If commodity prices recede and consumer confidence picks up, the MPC can always raise rates then from a position of strength. In the meantime it will be monitoring inflationary expectations closely and if the gilt market's implied rate begins to rise towards 4% it should be ready to press the button," Scott concluded.