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Inflation, Interest Rates & MPC
The UK economy is in an interesting situation with the interest rate cycle being out of step with the economic cycle. This gives the MPC a very difficult situation to deal with.
When these two cycles are aligned we would see low interest rates when the economy was in and moving out of recession. As the economy recovers and GDP growth improves we would expect to see inflation rise.
This is seen to occur because as the economy grows individual wealth increases leading to increased demand for goods and services. The supply side of the economy cannot keep up with demand and so prices rise, hence, inflation.
So, under the mandate given to the Bank of England, the MPC would start to raise interest rates. Economic theory supporting this approach believes that the increase in interest rates reduces demand as it removes spending power from the economy. This is certainly true for indebted individuals and companies as the cost of servicing the debt increases leaving less to spend on goods and services.
In addition higher interest rates provide better returns on savings and this too helps to reduce spending as saving is rewarded.
By removing the demand side of the economy in this manner inflation can be controlled.
Interest rate control as an inflationary tool is seen as an effective measure as the effects of an interest rate change feed through to the economy relatively quickly.
So normally we see inflation developing in a strong and quickly growing economy.
This is not the situation we face in the UK.
Inflation, measured by CPI, is at 4% - double the target level - whilst the latest economic data showed the UK economy actually contracted in Q4 2010. Even allowing for the impact of the snow the economy still contracted.
So the MPC has to deal with the scenario of increasing inflation (seen as a bad thing for an economy) which demands an interest rate rise response. This is combined with a very weak economy which would require cutting (is this even an effective option when base rates are at 0.5% anyway) or at the very least maintenance of a low interest rate.
Whilst increasing interest rates met help control inflation, it could equally snuff out what little economic growth we do have in the UK.
Being a member of the MPC at the moment is not an enviable job!
February 2011
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