There has been a lot of fuss recently about rising inflation. Each months' figures have been greeted by gloomy news stories portraying the upward drift of inflation as a problem. The odd thing is that the rate of inflation is still below the the government's target. Not one of the news stories I've seen or read has pointed out that an inflation rate two percentage points below the 2% target is a much bigger problem than a rate two percentage points above.
Will the Bank of England raise interest rates to slow inflation? Obviously the Bank will not want to push inflation down below today's level when it is below the target. The fear here is of inflation continuing to rise. The fall in the value of the pound from the middle of last year is the main reason for expecting inflation to rise. (Indeed, the exchange rate may also explain why the news reports are so gloomy. Some people are on the lookout for bad economic news to support their view of the world after the events of last June.)
Action by the Bank takes about two years to have full effect. Today's interest rate decision will influence inflation in two years time. A rise in import prices will push up the rate of inflation today and then disappear from the inflation figures in one years time. Of course the fall in the exchange rate also takes time to impact inflation, because firms absorb some of the increase in their costs and because some prices are fixed in contracts.
The conclusion is that a rise in interest rates now would have the effect of slowing inflation at the point when it would be slowing anyway. The result could be to push the economy into deflation.
I don't expect the Bank to make any serious change to interest rates in response to the exchange rate.
What would induce a rise would be if wages began to rise significantly. Particularly if it looked like firms were paying more because labour was in short supply. Despite the gloom about stagnating incomes, we might be closer to that point than we think.
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