No rate rise

If not now, then when?

The MPC again ducked out of the difficult but necessary task of raising the bank rate. It is not obvious what they are waiting for. Inflationary pressures have grown considerably stronger over the last six months. The MC have just sat there in their oak panelled meeting room, watching passively as the rest of us have inflation hit five percent.

Wishful thinking won't deliver price stability. Talking tough doesn't do it either. The only known cure for rapidly rising prices is higher interest rates.

King fails to convince the Treasury Committee

Mervyn King is again trying talk down inflation. He told the Commons' Treasury committee that "inflationary pressures [will be] pretty much back to target by around the middle of this year".

King confirmed that the Bank's counter-inflationary strategy is unchanged. It will try and wait out what it regards as a series of one-off shocks such as higher taxes and oil prices. By the summer, these effects will have fed through into consumer prices and gradually fade out thereafter.

However, he had to concede that inflation will rise at a seasonally adjusted annualised rate of almost 7 per cent this quarter. He also had to acknowledge that the inflationary outlook could deteriorate if the political situation in Middle East went pear-shaped, leading to a further increase in the cost of oil.

He also had to admit that the Bank had under-estimated the impact of both the commodity price inflation and the persistent effects of the exchange rate depreciation.

So to summarize; the bank believes that inflation will fall all by itself; there are alarming downside risks to the inflationary outlook and the Bank has accumulated an uneviable record of under-estimating inflationary pressures.

That settles it; no need for a rate rise.

Andy Sentance explains why a rate rise is necessary

Andy Sentance lays out the case for a rate rise in a recent speech entitled - Ten good reasons to tighten:

The MPC is accountable through its mandate to keep consumer price inflation at 2%. The mandate acknowledges that fluctuations will take place due to factors outside the MPC’s control. However, such factors causing deviations of inflation from target might be expected to be temporary rather than persistent. That has not been our experience, though.

Inflation has been above target for most of the time I have been on the MPC and some of the upward deviations have been quite significant. This creates a much stronger platform for tightening monetary policy than if we had experienced simply a “one-off blip” in inflation. The average CPI inflation rate while I have been on the MPC – since October 2006 – has been around 3% and over the past three years it has averaged 3.5%. In January it was 4.0%. In addition, CPI inflation is expected to rise higher in the short-term before falling back.

Indeed, since 2009, when the MPC put in place the current policy settings, inflation has persistently run ahead of the official forecasts set out in the Bank of England Inflation Report.

It is a must-read speech....

Rates must go up

Andrew Sentance, MPC member, again called for higher rates in the face of growing inflationary pressures:

"The time has come to increase interest rates. We should increase them gradually and slowly if we can. But the risk of delaying interest rate rises too long is that this gradual approach may cease to be an option in the future."

Six months ago it might have been possible to gradually increase interest rates. Unfortunately, the Bank of England is so far behind the curve that only a sizable rate hike will have a significant effect on rising prices.

Events in the Middle East have cruelly exposed the 'wait and see" stance of the more passive members of the committee. The sudden surge in oil prices will inevitably push inflation towards the top end of the Bank's inflation projection, at least in the short run. While a fall in the oil price is likely over the medium term, this decline won't come before inflation hits five percent. Indeed, if uncertainty in the oil market is protracted, then inflation could easily hit six percent by summer.

An earlier movement on rates, coupled with an unwinding of quantitative easing, would have put the Bank in a better position to deal the the recent commodity price shocks.

Now, the Bank must make up for the mistakes of the past. Delay will only make the evitable adjustment more painful. Rates must go up.

What is the trigger rate that finally forces the MPC to act?

At what rate of inflation would the monetary policy committee feel compelled to raise rates? It is certainly not four percent. We are there already and rates remain firmly fixed to the floor. Would it be five percent? Seven? Eleven?

There must be a number - a trigger inflation rate - where the MPC would finally act; a point where the costs of rapidly escalating prices are greater than any gains from protecting the banks and trying to revive the economy with cheap money.

Whatever the answer, the MPC have to deal with a rather unpleasant consequence of a near zero bank rate. The higher that trigger rate of inflation, the further the bank rate must travel before they can bear down on rising prices. If, say the inflation rate were cruising at a steady 7 percent a year, then a 25 basis point increase is unlikely to make much of a difference. The adjustment, if it is to be effective, is likely to be very nasty. There is always a cost for delaying the inevitable.

The crisis in the Middle East isn't giving any comfort to the MPC that it can avoid the trigger rate question. The oil price is swinging around violently with each political shock. Nevertheless, the trend seems unmistakable. Oil is at a two-year high. Today, Brent crude prices in London hit $105 a barrel today. If that price were sustained, then the Bank of England's central forecast of 5 percent will end up being a tad too optimistic.

It wouldn't be the first time that the Bank's optimism has led it to under-estimate external pressures on the CPI. Indeed, recent bank inflation forecasts have exhibited a strong bias towards under-predicting inflation. A cynic might suggest that these biases play a key role in rationalising the low interest rate policy stance of the MPC. The forecasts tell a pleasing story that lower inflation will eventually arrive, so long as everyone is prepared to wait out these recent external shock.

Instead of hoping for the best and pretending that inflationary pressures are temporary, the Bank needs to be looking closely at downside scenarios. For example, how would UK consumer prices react to political unrest in Saudi, with its inherent risks of disrupting oil supplies. What would happen to inflation if wage pressures in China were to increase?

Such scenarios cry out for a higher bank rate. They would also starkly illustrate that the magnitude of the interest rate adjustment will have to be large, thus exposing the MPC to the charge that it should have raised rates much sooner.

In fact, pushing rates down to zero was an over-reaction, largely driven by panic. It had a certain theatrical quality. The MPC acted like a magician, hoping to dazzle the audience with an unexpected trick.

With inflation now heading for five percent and possibly higher, the MPC might need to pull out their top hat and cape and prepare to play another trick with interest rates. How does a 300 basis point rate increase sound? Not shocking enough? Would 500 basis points be sufficient to have us gasping for breath?

Playing catch up

"We (the monetary policy committee) would be better placed to head off the upside pressures on inflation which are now apparent if we had taken earlier policy action.

And the risk is that when policy tightening does start, it will be overdue and the MPC will be playing catch-up – which is not a good scenario for recovery prospects."

Andrew Sentance, external member of the Bank of England's monetary policy committee

The monetary miracle is over

One should never underestimate the importance of luck. For almost a decade, the Bank of England proved to be very fortunate. It managed to simultaneously keep interest rates low, dramatically increase the money supply, and at the same time meet its inflation target.

How did it pull off this monetary miracle? The chart above provides a comprehensive explanation. It breaks the CPI inflation rate down into two components; the rate for services, which are mostly produced domestically; and rate for goods, which are almost entirely imported into the UK.

As the chart illustrates, prices for domestically produced services have grown fairly consistently at between three and four percent a year. This is far in excess of the Bank of England's inflation target. Prices of goods, on the other hand, were falling between 2000 and 2006, exerting powerful downward pressure on the aggregate inflation rate.

The reason for this negative inflation rate for goods is well understood. China industrialised, and exported huge quantities of clothes, footwear, and electronics. Prices for these items fell massively. In contrast, domestically produced prices increased rapidly in response the the extraordinary surge of Bank of England inspired monetary growth.

For many of us, this inflationary dichotomy between its goods and services will ring true. Anyone who regularly hired an accountant or chose to educate their children privately will be familiar with the four percent a year price hike.

So, it is fairly easy to see how the Bank of England got away with loose monetary policy and low inflation. Nevertheless, there is a more intriguing question embedded in this chart. To what extent did the surge in goods prices trigger a financial crisis?

To see how the turn-around in import prices might have precipitated the crisis, it is worth remembering how monetary policy worked in the past. In previous decades, rapid credit growth would have quickly fed through into prices. Eventually, interest rates would have increased, credit growth would have subsided, the economy would have slowed, and eventually inflation would have moderated.

This didn't happen in a decade before the crisis. Credit exploded while the overall inflation rate remains subdued on account of cheap imports. The Bank of England didn't feel obliged to raise rates, and the credit bubble just kept on growing.

Unfortunately, the old trade-off, like an unwelcome relative, returned in 2006. Inflationary pressures were building in the East,and import prices began to increase.

There were tentative signs of trouble in 2005. The Bank of England made a half-hearted attempt to raise interest rates to stem inflationary pressures. But the monetary policy committee took fright when it saw the property market weaken. Rather than tackle the growing inflationary menace, the committee buckled, reduced the bank rate and gave the housing bubble a new lease of life.

This weakness before the inflationary enemy resulted in renewed price pressures. In the early months of 2007, the Bank of England and its sister institutions in the US and Europe, were belatedly hiking interest rates.

This changing policy stance was sufficient to expose all the poor lending practices and financial sector abuses that had built up through the previous decade. Many banks, particularly small ones like Northern Rock, had cut interest margins to the bone and jacked up their leverage ratios. The slightest perturbation of interest rates and the financial system was in deep trouble.

The rest of the story you know.

So here we are - four years on from the crisis - and inflation has hit 4 percent, and it is likely to go higher. The Bank of England now believes itself to be trapped. It fears to raise interest rates on account of what it thinks a rate hike might do to the frail recovery. As for dealing with inflation, it has no strategy. There is no plan, just a vague hope that somehow things will turn out alright in the long run.

In fact, there never was a plan. The only thing that kept inflation down for ten years before 2006 was luck and a flotilla of Chinese cargo ships packed full of goods.

Watch out Mervyn, the press are starting to turn....

The UK press are starting to question Mr. King's competence...


The Guardian

His letter to George Osborne had a familiar ring about it. Yes, inflation remained well above target, but that was due to the weakness of sterling, rising commodity prices and the increase in VAT. For some in the markets, this explanation is wearing thin, and has become as unconvincing as the boy who tells teacher that the dog ate his homework.

The Telegraph

Cheap money has thus not only fuelled inflation, but has created a climate in which talk of any rate rise triggers concern that we may be tipped back into recession. Stuck in this vicious circle, it is no surprise that Mr King openly acknowledged yesterday that the MPC is split on the future direction of policy.

BBC

Mervyn King's 10th letter to Number 11 Downing Street is similar to many of the other ones he's written. In his view, the 4% rise in the CPI in the past 12 months is unfortunate - but temporary, and almost entirely driven by factors beyond the Bank's control. He insists that the MPC has not "lost control of inflation".

The Spectator

Now that today’s inflation figures are up, to a predictable and predicted 4.0 percent on CPI and 5.2 percent on RPI, we can expect the usual response. Nothing from the government (even though the declining standard of living will eclipse cuts as the no.1 problem of 2011); plenty of shocked news stories; and, then, the round of commentators saying that Mervyn King should “hold his nerve,” and not increase the absurdly low base rates of 0.5 percent. Inflation is temporary, he says, and should be okay again this time next year (that’s what he said about the start of 2011).

Looking through inflation

I enjoyed reading these paragraphs in Philip Aldrick, and Emma Rowley piece on inflation, which appeared in the Telegraph:

For the past three years the (Bank of England) has got inflation consistently wrong. Just last year, it predicted the current quarter's inflation figure would be 1pc. When the ONS publishes a figure four times that level on Tuesday, it will only aggravate concerns.

The Governor and his cohorts have a formula for dealing with overshoots now. The Bank needs to "look through" inflation, King says. Shear off the one-off events, oil price spikes, poor harvests that lead to food price rises, the inflationary effect of the pound's devaluation and the VAT rise. Strip all that out and domestically generated inflation in the past four years has been "close to zero and obviously well below the target", King said in Newcastle last month.

"Looking through inflation" - as if we couldn't see it every time we enter a supermarket.

Aldrick and Rowley’s article hints at some deeper problems of monetary policy management. Over the last quarter of the 20th century, a consensus developed that price stability should be the primary focus of monetary policy.

In order to deliver low and stable inflation rates, a parallel consensus emerged. Central banks should be independent of political control and receive a unambiguous mandate for which they are then held accountable.

In order to make this mandate operational, Central banks needed a data-based standard. This meant choosing a single price index, which was compiled independently of the central bank. A third consensus developed. The Consumer Price Index was to be that benchmark, and it was to be produced by an independent national statistical office. (As an aside, I always thought that this was the wrong benchmark, because it excluded house prices. But let’s leave that objection at the cloakroom for fear that it might obscure my central argument. )

In summary, modern monetary policy had arrived that three points of agreement:

• Monetary policy should be directed towards price stability:
• Central banks should be independent:
• The CPI should be the metric for measuring the central bank’s success in meeting its primary objective.

Unfortunately, the Bank of England failed to abide by this social contract. Instead of maintaining price stability, it has chased growth with paltry results and kept the banking sector afloat at the cost of higher inflation.

This race for growth has compromised its independence. Today, the monetary policy committee looks more like a gaggle of incompetent and unelected politicians rather than a group of competent, rational, data-driven bankers.

As for the transparency of the CPI benchmark, the Bank has tried to detract our attention from it by a litany of self serving excuses about global shocks, oil prices, VAT and whatever else seems convenient to put forward as an explanation for unacceptably high inflation.

It is all rather disappointing. There was a time when I though an independent central bank was the answer. Perhaps, this explains my anger what has come to pass as monetary policy. The consensus could have worked, if only the MPC had understood what it had signed up for - keeping inflation under control.

Inventory? What inventory?

Does the lack of movement in published grain stocks invalidate any claim of a connnection between monetary policy and food price inflation?

New York journalist and one-time economist - Paul Krugman - thinks so. He doesn't see an "accumulation of inventory." Higher inventory would suggest hoarding, an important "signature" or marker of speculation. This point about inventory is mostly directed towards wheat, which has seen an extremely sharp run-up in prices.

Since Krugman lives in New York, it is perhaps understandable that his knowledge of farming is a little limited. There is no such thing as data on inventory. The USDA produces a time series called grain stocks.

This number is not the same as inventory, at least not in the sense used by Mr. Krugman. This stocks number has very limited coverage, focusing mainly on government holdings of grain. The USDA produces these estimates largely by looking at grain reserves in the US and reading reports produced by other governments.

Most countries run strategic grain reserves, and there is some limited data for what governments are holding. However, these reserves are disbursed across many sites across the world. Often there is wastage, theft, and misreporting. To put the issue in perspective; does anyone really think that the grain supply numbers coming out of say, Chad are accurate? Undoubtedly, the Chadian authorities are doing their best, but gathering comprehensive data on grain storage is not as easy as New York journalists might think.

In some parts of the world, grain markets are subject to government intervention, and price controls. This increases the incentives for corruption and misreporting. In more than one country, grain reserves have mysteriously disappeared, especially when food prices have suddenly accelerated. We should never forget there are some very powerful incentives at work here.

To make the point more forcefully, does anyone really think they know how much grain the private sector are holding? If private wholesalers are hoarding grain, I doubt very much that are reporting their stocks accurately to government officials. If prices are going through the roof, the incentives to hide grain are very potent.

Just to be clear, I am not saying we know nothing about grain stocks. I am sure the numbers coming out of the US, the EU and Canada are reliable. But strategic grain stock numbers from Russia, Kazakhstan and Ukraine? There I pause for a moment and wonder. Maybe, these numbers might be in the ballpark of the truth, but I would treat them with caution. As for private sector holdings of grain, only the Almighty knows that number.

There are estimates of production, which are partly taken from satellite imaging, and assumptions about yield per hectare. There is an obvious relationship between amounts produced last year and likely stocks this year. It is helpful, but I would feel uncomfortable about relying on those numbers.

Furthermore, when I hear that the USDA project a 5 percent decline in production, I am inclined to believe it. Nevertheless, reported harvests have been very good over the last few years. Even a five percent decline still puts the projected 2011 harvest up there in the top five years over the last two decades or so. However, none of this tells me very much about the true underlying level of world inventories.

Nevertheless, we shouldn't take too seriously any argument suggesting that speculation in food markets is implausible, simply because there is a lack of inventory build-up. It is the sort of argument that city folk make. Country people know better.

We must rely on what we can see; prices. We need to make a judgement about whether prices have deviated from long run fundamentals. As my last post indicated, prices seem to have jumped a long way from trend. To me, this smells of speculation.

Just what we need right now; an oil price bubble

The crisis in Egypt is doing wonders for the price of oil. As demonstrators filled the streets of Cairo, the price of Brent crude hit $100 a barrel, its highest level for two years.

However, it would be misleading to think that the political crises in North Africa is the main driver behind the recent spike in oil prices. The crisis has helped over the last month or so, but the market has been trending upwards since the summer.

Cheap money, lots of speculation and a growing expectations of inflation - these are the factors driving the price of oil higher.

It is a cold breezy day in New York....

Here is a future scenario where the dollar collapses. The timeline suggested in this video seems too tight.

It reminds me of that quote from Mark Faber:

I am 100% sure that the U.S. will go into hyperinflation. Not tomorrow, but the problem with the government debt growing so much is that when the time will come and the Fed should increase interest rates, they’ll be very reluctant to do so and so inflation will start to accelerate.

-Marc Faber, Bloomberg, May 2009

The interest rate hike is on its way

A rate hike is looking more likely. Here is Martin Weale, the newest member of the Monetary Policy Committee, writing in the Guardian.

As we cast our votes at the January meeting of the Bank of England's monetary policy committee – ahead of last week's GDP figures – I saw a compelling case for an increase in the bank rate.

My concern is that, if businesses and pay-bargainers come to regard an inflation rate of 3%-4% as normal, it will become more costly for the MPC to keep inflation close to the government's 2% target.

The longer inflation stays above the target and the further it rises, the greater the risk that inflationary expectations will become built in.

A rate hike at the next MPC meeting looks very likely.

It wasn't me says the Governor

A sign of genuine leadership is a willingness to accept responsibility. Sadly, Mr. King's recent speech in Newcastle was an unconvincing exercise in blame displacement.

As Governor of the Bank of England, his primary task is to ensure a stable price level. However, UK inflation is spinning out of control. So how does Mr. King deal with this seeming contradiction.

In his speech, he offered three explanations for the recent rise of inflation. The UK economy has suffered from three shocks; higher import prices, higher energy costs, and higher VAT rates. He implies that neither he, nor the MPC, bear any responsibility for these developments.

Of course, this isn't quite correct. Let us start with import prices. The reason that import prices are higher is because sterling has depreciated. The exchange rate is the relative price of a currency. If a central bank increases the supply of its currency, then the price will fall.

This is exactly what the Bank of England did, and explains why Sterling is worth so much less than three years ago. Therefore, the Mr. King and the MPC are directly and uniquely responsible for higher non-fuel import prices.

What about fuel prices? Surely, Mr. King is innocent. Sadly not. He must bear some responsibility here. While it is true that the monetary policy of the UK has only a minimal effect on world energy prices, it is not true of the aggregate behaviour of all central banks. If each of the major central banks decide to loosen monetary policy and inject massive amounts of cash at a global level, then world energy prices will rise.

The Bank of England, along with the Fed, the ECB, and the BoJ, all simultaneously loosened monetary policy in the autumn of 2008. This wasn't an innocent coincidence; this was a coordinated effort. Two years later, inflation is picking up, just as monetary theory would predict. The BoE, along with other central banks, are therefore responsible.

Mr. King's responsibility for the VAT hikes is more indirect. The Bank of England was negligent throughout the decade prior to the crisis. It acquiesced to a massive asset bubble, that eventually burst and nearly brought down the financial system. Unwisely, the government responded to this crisis with wide, short-sighted changes to VAT rates. While Mr. King was not directly responsible for these policy vacillations on VAT, he was responsible for creating the permissive environment that allowed politicians to behave so badly.

Whatever excuses Mr. King may furnish for past mistakes, one thing is clear, the jig is up. Inflationary momentum is increasing, and there is only one way to pierce the boil - higher interest rates. The time for excuses are over. The time for leadership has arrived. Mr. King needs to step up and do what has to be done.

How well has the Bank of England forecasted the inflation rate?

How have the Bank of England's recent inflation forecasts compared with actual out-turns?

Before that question gets an answer, we need to acknowledge that economic forecasting is extremely difficult. So we shouldn't be too hard on the Bank simply because it can not precisely forecast the inflation rate 24 months ahead.

The Bank of England present their forecasts with a considerable degree of modesty. In addition to their central forecast, they also publish upper and lower bounds that indicate the degree of uncertainty that the Bank attaches to its forecast.

Therefore, one shouldn't place too much emphasis on whether the forecast is right or not. Instead, it is much better to think of the forecast in terms of what it reveals about what Bank of England is thinking and how it views recent macroeconomic developments.

So what do recent forecasts reveal? The chart above illustrates the Bank's forecast between May 2008 and February 2010, along with the actual out-turn for inflation. Ironically, the most accurate long-term Bank forecast is the oldest. The May 2008 inflation forecast was rather pessimistic. The Bank expected inflation to remain above the 2 percent forecast for several years ahead. Although this forecast missed the slowdowin of inflation in 2009, it wasn't too far off for 2010.

From November 2008 onwards, the Bank sharply revised their forecasts. They began to expect a sharp deceleration in inflation. They got this right; inflation did come down sharply. In September 2009, it was just 1.1 percent.

Then things went off track for the Bank's forecasters. Inflation picked up sharply in the closing months of 2009. It is given a further boost with the resumption of the higher VAT rate in January 2009. Curiously, the VAT hike was pre-announced, so it was surprising that the Bank didn't capture the uptick in their forecast during the early part of last year.

However, the most revealing forecast is the one from February 2010. By then, the Bank had caught up with the VAT shock, and managed to get the q1 forecast more or less spot on. Thereafter, things start to go wrong. The Bank expected inflation to fall, very much as it had in the winter of 2008. Instead, the rate went the other way.

In forecasting terms, this was a near term miss. In other words, the recent surge of inflation caught the Bank of England completely by surprise. The normal response to such situations is to completely rethink one's assumptions. The next inflation rate will make particularly interesting reading as the Bank struggles to explain this divergence between their recent forecasts and the inflation out-turn.

So what does this tell us about UK monetary policy? Two things; a further round of quantitative easing is now extremely unlikely and an interest rate hike is coming sooner than previously expected.

UK inflation is spinning out of control

December’s inflation number wasn’t just bad, it was horrific. In just one month the headline CPI rate went up from 3.3 to 3.7 percent. The retail prices index now stands at 4.8 per cent.

To give the December number some context, the CPI rose by one full percent in just one month. This was a record increase. Between 1996 and 2008, the 1-month change between November and December has varied between a fall of 0.4 per cent and an increase of 0.6 per cent. So, the latest number was off the scale. Moreover, this number does not include any of the recent VAT increase. That will hit the index next month.

Notwithstanding the unprecedented nature of the December number, the further deteroriation in inflation should not come as a surprise to anyone. Over the last three years, the Bank of England cut interest rates to near zero, and then followed up by printing billions of pounds. This increase in the money supply has pushed sterling down against all major currencies.

Over in Whitehall the government is running a double digit fiscal deficit, while public sector indebtedness has exploded. It has vacillated over indirect taxation, first cutting the VAT rate and then increasing it twice. Furthermore, these measures were undertaken when oil prices have doubled, and food price inflation is surging. If ever there was a recipe for inflation then this is it.

The standard line to justify this chaotic catalog of policy initiatives is that the financial system has suffered a terrible blow and that these interventions were needed to prevent a 1930s style depression. While it is true that lending activity has slowed, the decline is very much in line with previous post-war UK recessions. Unfortunately, policy makers were far too prone to hyperbole when describing the reasons for their hysterical attempts to keep growth buoyant.

The near-term prospects for inflation are awfully bleak. Without a spectacular change in monetary policy, inflation is going in only one direction. Growth is now picking up, price expectations are rising, and all we need to put us into double-digit inflation territory is a further oil price shock, a renewed surge in food prices, and a marginal acceleration of wage growth.

The monetary policy committee is now cornered. There are no excuses left. There are no more stories to tell about the output gap and how higher unemployment will eventually bring inflation down in the medium term. Without a policy response inflation will quickly slip into double-digit rates in a comparatively short period of time.

There is an understandable concern about how higher interest rates might impact growth. At this stage, a darker scenario is lurking in the corner - capital flight. If investors start to believe that UK inflation will go higher, then either long-term rates rise accordingly, or investors go elsewhere.

This dilemma is likely to manifest itself first in the government bond market. If long rates start to rise, then debt servicing costs will increase as well. Rising long term government bond rates was the trigger that pushed Greece and Ireland over the edge into a full-scale fiscal crisis.

There is one glimmer of hope. The coalition has announced a fiscal consolidation plan that appears to be credible. This has bought the UK economy some time. However, the clock is ticking and that credibility could evaporate as long term interest rates start to rise, putting pressure on a vulnerable deficit position.

The options facing the monetary policy committee are difficult. However, the dangers inherent in a passive approach are exceedingly unpleasant. Whether the MPC likes it or not, the time for a rate hike has come.

Rhetoric and reality

Reading the Bank of England's internet site always makes me laugh. There is a wonderful disconnect between rhetoric and reality. The bank talks a good game when it comes to inflation. Here is what they say about their principal objective:


A principal objective of any central bank is to safeguard the value of the currency in terms of what it will purchase. Rising prices – inflation – reduces the value of money. Monetary policy is directed to achieving this objective and providing a framework for non-inflationary economic growth.

This week, they had a chance to put their rhetoric into action. The monetary policy committee could have raised interest rates. Instead, they chose to do nothing, despite the growing and incontrovertible evidence that UK inflation is accelerating.

The reason for the decision is well understood. The monetary policy committee would like to keep commercial bank funding costs low. They would like to increase the difference between the interest rate banks pay to depositors and the rates banks receive on their loans. This is known as the fat spread strategy. Its purpose is to recapitalise the banks surreptitiously by imposing the costs on savers.

The absurdity of the situation is amply demonstrated by a simple thought experiment. Suppose that the financial crisis had never happened and that the Bank of England was faced with the same inflation data. What would be the most appropriate interest rate response to an inflation rate that has been above target for 40 out of the last 48 months? It would be a rate hike, of course.

It is time....

...for the monetary policy committee to finally raise interest rates.

Tomorrow, the committee begins its January meeting where it will decide if it will finally begin to tackle the growing inflationary momentum that is now building up within the UK economy.

Actually, the committee should never have cut rates down to almost zero in the first place. It only served to destabilize the economy, creating an atmosphere of panic and self-fulfilling expectations of a recession. It also created perverse incentives, and transferred huge amounts of income away from prudent savers to speculators and debtors. However, that is last year's debate. The important thing is this week's decision.

The UK economy would gain enormously if rates were increased. It would offer a powerful signal of a return to economic normality. This would create the basis for improved consumer expectations, sustained investment and economic growth.

A rate hike would break the dependency culture within the financial sector. Banks would have to restructure their operations without the oppressive public sector safety net. It would also encourage an increase in bank deposits, which would stabilise funding and reduce reliance on flighty wholesale financial flows.

There is, however, a more important reason for an immediate rate hike. The bank needs to prepare for the next crisis.

Whether we like the new world of deep public expenditure cuts or not, the coalition's austerity program has bought the UK economy some time. Financial markets believe that the programme is serious and therefore government bond rates remain comparatively low.

At the moment, financial markets are flying on the fumes of a fiscal consolidation. So far, the coalition has promised much but delivered very little. The deficit continues to be extremely large, tax revenues have not recovered, and expenditure is still rising.

Nevertheless, the coalition has gained the confidence of financial markets. This gives the bank a short window of opportunity. The coalition's credibility will allow the Bank to begin raising rates at a moderate pace, providing a powerful signal that it is ready to tackle inflation, and without strangling growth.

There is still a danger that the UK could face a perfect economic storm in the near future. Suppose the coalition's austerity program fails to reduce the deficit as quickly as planned. This will mean that the government will have to go to the bond market with a large funding requirement to cover an unexpectedly large deficit. If at the same time, inflation has the government could face a sudden change in market sentiment that could see bond rates increase sharply.

It is precisely these kinds of funding difficulties that have forced Greece, Ireland, and Portugal into extremely painful adjustments. Yet these adjustments were undertaken when inflation remained subdued. Imagine, for a moment the consequences for growth if the the Eurozone basket cases also had to raise rates in order to curb inflation?

If the Bank begins to raise rates now, it would put downward pressure on prices, and reduce the risk of this perfect storm. It would also re-establish a decree of control of monetary conditions; something the bank lost once it cut rates down to almost zero. This would also give it some room for maneuver should growth begin to slow.

The alternative - maintaining the current level of interest rates, would gain the bank nothing. True, it would offer commercial banks cheap financing, but it would continue the overwhelming pall of instability that now smothers the UK economy.

It is time to put an end to the financial crisis. It is time to increase the bank rate.

Whatever happened to self certified loans?

Before the financial crisis, the UK banking system offered around 750 self certified mortgage products. By the beginning of 2010, all those products had disappeared. The self certified mortgage is no more.

UK banks seem to learn something about lending. It was a simple lesson, but costly one. When writing out a loan, it's usually worthwhile to check out the documentation offered by the borrower.

UK Economy - Household bank deposits shrink

Negative real interest rates have destroyed any incentive to use the UK banking system as a means of saving. Near zeri rates gave ensured that household checking deposits are declining, while the growth of time deposits has fallen sharply.

At first glance, this may not seem much of a problem. After all, the Bank of England wanted the nation's households to go out and spend. Higher savings rates means lower consumption and lower output.

However, the Bank of England also wanted commercial banks to find more stable sources of financing. The wholesale money markets have proved to be too volatile. Furthermore, UK banks have a large amount of funding maturing next year. Some banks may find it difficult to replace that funding at low interest rates.

Household deposits would provide a more stable alternative to flighty capital from the wholesale market. Unfortunately, householders need to receive a positive rate of return before they put money in a bank.

This is just one more reason why UK interest rates must rise.