U.K. Inflation. Why raise interest rates?

Question

Hey there, thanks for taking the time to answer. I'm a very capable economics student but I am failing to understand why two members of the Bank of England wish to raise interest rates in order to cause disinflation when it appears to me that the recently high U.K. inflation rate of 3.7% is actually being imported. Therefore it is being caused by increasing demand of rapidily developing economies such as China, India and South American countries.
So therefore I would really appreciate it if someone could explain how raising interest rates will help curb cost imported inflation? (I acknowledge that higher interest rates would lower spending on imported goods and therefore less of the imported inflation; but what other explanations are there? Especially seeing as a majority of the imported inflation is due to rising oil prices which is a necessity in the current economy and thus the demand for it cannot be influenced majorly)

Answer 1

A very complex and controversial subject. The question is should the BoE increase the interest rates because headline inflation is with 3.7% higher than expected, and above the target inflation of 2%, in a situation where the UK economy contracted by 0.5%, mostly due to the austerity program of the conservative government. It comes down to the question, which goal takes priority: fighting inflation by increasing interest rates and thereby imposing further hardship on the already weak economic recovery, or leave interest rates at a historic low level to partially offset the negative impact of the government austerity program but risking soaring inflation in the future. Not an easy decision and economists are divided.



It comes down to two main questions: (1) how fast is the economy going to recover, and (2) how serious is the threat of future inflation. The first question is easy to answer: the austerity program of the UK government will result in a very slow recovery at best. The second question is more difficult, and can be seen from two angles: how relevant are the headline inflation numbers, which include food and energy prices that fluctuate all the time, versus core inflation which excludes these volatile items. As you correctly point out, the current headline inflation numbers are the result of food and commodity prices which show an increase of food prices caused by bad weather and higher demand from growing developing countries, such as China. Many economists therefore argue that the 3.7% headline inflation rate may not be an accurate metric for the inflation risk. The core inflation, on the other hand, which excludes these volatile items is more relevant because it includes only prices that are much slower to react downwards (sticky prices) once they are embedded in the economy.



The other aspect to consider is that interest rate decisions are made not with current inflation rates in mind, but targeting furture inflation rates. In other words, they need to consider the inflation expectations in the economy. And there Paul Segal has a very good comment in the FT:

http://blogs.ft.com/economistsforum/2011/02/remember-why-inflation-expectations-matter/



He argues that the actual higher than expected inflation rates will not necessarily lead to higher inflation expectations in the current economic environment. Any rate increase would therefore be counterproductive.



Unfortunately, nobody can predict the future with sufficient accuracy to remove the element of uncertainty fom such critical decisions. As a result, different economists have different views on what course to take.

Answer 2

The latest CPI and RPI figures have shown a significant jump in the rate of inflation, adding credence to the increasingly widespread calls for the Bank of England to raise interest rates from their current historic low.



The rate of inflation in the UK has risen significantly according to the latest CPI and RPI measures, increasing pressure on the Bank of England to raise interest rates in a bid to cool off further price inflation.



The Consumer Price Index (CPI), which measures inflation using everyday consumer and household goods, increased from 3.3% to 3.7% in December – almost double the target level of 2% the Bank of England is committed to maintaining.



The RPI, a distinct measure of inflation, also reflected a rise in the rate of inflation, up to 4.8% from 4.7%. And with the impact of a 2.5% increase in VAT in January yet to factor fully into inflationary considerations, some analysts are suggesting inflation could continue to pose problems throughout 2011.



High inflation is seen as economically problematic, and there are growing calls for the Bank of England to raise the base interest rate of interest from its current record low of 0.5%.



However, some commentators are concerned that a rise in interest rates now could compound economic difficulties, increasing the cost of living and doing little to calm inflation caused by rising commodity prices.



The Monetary Policy Committee of the Bank of England, who met last week, agreed to hold interest rates at 0.5% for at least another month.

Answer 3

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