Planning to go to Europe on holiday this year?
Then the Bank of England’s monetary policy committee (MPC) had some surprise good news for you yesterday.
One of the biggest advocates of quantitative easing (QE), Adam Posen, seems to have been rattled by inflation. He decided against asking for more money printing at the last meeting of the MPC.
That gave the pound a little jolt higher, while markets started to price in an earlier rise in UK interest rates.
Could this mark a turning point?
Why the Bank of England is always too optimistic on inflation
In case you hadn’t already figured it out, the Bank of England is not very good at predicting the future rate of inflation.
Earlier this week, we learned that consumer price index (CPI) inflation picked up to 3.5% in March. In the February inflation report, the Bank had predicted 3.35%. Last February, it predicted we’d be down below 3% by now.
More importantly, inflation hasn’t been below the Bank’s central 2% target since 2009.
You can forgive the Bank for getting it wrong – no one has a functioning crystal ball. But the fact that inflation consistently beats the Bank’s forecasts is a bit less easy to forgive.
Of course, there’s a very good reason why inflation always overshoots rather than undershoots. It’s because the Bank isn’t really trying to predict the course of inflation. It’s trying to keep our expectations ‘anchored’.
The job of the Monetary Policy Committee is to keep CPI inflation within 1% either side of 2%. That’s their only explicit goal. So if they’re not achieving it, Bank governor Mervyn King has to give a reason why.
He can’t turn around and say: “We’re not hitting our CPI target because we think that’s less of a priority than propping up the banks and trying to grow the economy.” That’s not within his remit.
All he can realistically say is that the Bank didn’t expect inflation to be at this level – but don’t worry, because it’ll be coming back down before too long. It’s the central banker’s equivalent of saying the dog ate your homework.
And to be fair to the governor, he’s got away with this ploy for nearly three years now, so you can see why he keeps using it.
Don’t bet on tighter monetary policy soon
However, he might be running out of room for manoeuvre. As Simon Ward of Henderson points out, the latest forecast-beating figure can’t be blamed on the usual ‘short-term’ culprits. It’s nothing to do with VAT: “the CPI excluding indirect taxes (CPIY) also rose by 3.5%”.
Meanwhile, rising food and energy prices “seem to reflect domestic pressures in these sectors rather than global commodity price developments.” Commodity prices as a whole were barely changed in the year to March, compared to double-digit growth the previous year.
As for sterling, it has strengthened slightly – up 1.5% – in the year to March 2012.
In short, CPI inflation isn’t rising because of ‘short-term’ pressures or ‘one-offs’. It’s going up because prices are going up.
This gives credence to the idea that Britain’s economic capacity is tighter than perhaps the Bank likes to think. In other words, as the FT puts it, the recession might have reduced “how fast [the economy] can grow without stoking inflation.”
That’s something that should worry the Bank. And it clearly has.
Minutes from the Bank’s April interest-rate setting meeting showed that Adam Posen – who has been calling for more QE consistently – stopped calling for it. Just one member, David Miles, asked for more QE this time round.
This is hardly suggestive of a rampant return to stringent monetary policy. But it was more aggressive than markets had expected. Is it a signal that rates are set to rise soon?
Don’t bet on it. The Bank has been talking tougher on inflation this week. Paul Tucker, the deputy governor of the Bank, admitted that inflation could well remain above 3% into the second half of this year. He also warned that any sign of economic recovery might see companies passing price rises on to customers more aggressively.
However, this is all part of the Bank’s ‘anchoring’ technique. If they step up the rhetoric against inflation just now, it helps them to manage expectations.
For example, Tucker added that “monetary policy will underpin the recovery so long as that remains consistent with anchoring inflation expectations in line with achieving the 2% target over the medium term. We will not let that slip.”
‘Medium term’ could mean anything. It’s certainly not a suggestion that the Bank is planning on interest rates budging from 0.5% this year or even next.
What does this mean for your money?
The Bank will keep interest rates low for as long as it can. And while inflation remains roughly where it is now – below 5%, let’s say – it’s not scary enough to rattle the public.
Don’t get me wrong. Inflation at 3.5% a year will do plenty of damage to your savings if they’re earning 0% interest. But as a headline number, it hardly screams ‘Weimar’ to the man in the street.
I reckon that once you start approaching 6%, people start noticing. They start to really worry about getting some protection. They start to ask why the Bank isn’t doing anything. But in the meantime, the Bank will talk tougher, but it won’t actually act.
What does it mean for your money? You can expect inflation to remain ahead of interest rates for one thing. That means you should take advantage of all the tax breaks you can get. My colleague Phil Oakley compared the benefits of Individual Savings Accounts (Isas), pensions, and paying off your mortgage early in a recent MoneyWeek magazine cover story.
As for the pound, more aggressive Bank rhetoric might help to keep it coasting higher, particularly if economic data backs it up. But in any case, a bigger influence will be the state of the eurozone. If the European Central Bank looks like printing money while the Bank of England is on hold, that’ll boost the pound versus the euro.
I wouldn’t be keen to bet on sterling versus the dollar, which is also strengthening just now, but a punt on the pound versus the euro might pay off. Do remember that spreadbetting on currency movements is pure speculation and highly risky – if you’re interested, sign up for our free MoneyWeek Trader email to find out more about spreadbetting.
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