Rates committee will not respond to deflation

Rates committee will not respond to deflation

The decision of whether or not to tighten monetary policy is “finely balanced”, according to Monetary Policy Committee member Martin Weale, who has claimed inflation can be returned to target “despite the international concern about very low inflation”.

Speaking yesterday at a sixth form college in London, the former National Institute of Economic and Social Research director explained that while “it is likely that inflation will fall below zero at some point in the next six months”, this is not something to which the MPC should respond.

“Our work suggests that a change to bank rate takes about two years to feed through fully to inflation.

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“The implication of this is that we should not try to keep inflation very close to target all the time; if we did that, we could be sure that interest rates would be extremely volatile, in a way that no one would find very helpful.”

Instead, he said that the effect from oil will begin to drop out in less than a year and the rate of inflation will gradually recover towards the MPC’s target.

“If wage growth continues to accelerate over the next few months, especially in the absence of a pick-up in productivity, then for me it strengthens the case for a rise in bank rate,” he added,

Mr Weale sought to explain the current low level of expected future rates which are much lower than they were a year ago, giving the example that the expected rate up to 2026 averages less than 3 per cent.

He stated that this “just about makes sense” if inflation is on average at its target and economic growth is materially below 1 per cent over the period.

“The first assumption is eminently reasonable… the second point is, perhaps, open to more debate. To grow at only one per cent for the next ten years would be extremely disappointing”.

However, Mr Weale pointed out that there are two other interpretations of long-term interest rates beyond very low inflation and weak growth.

One is that low rates reflect the returns investors are prepared to take in exchange for greater certainty. The other is that some people may not share his confidence and “they may be assuming not only that growth will be weak, but also that inflation will remain persistently below its target”.

Mr Weale said he was confident that the MPC can return inflation to target given the tools at its disposal and that the committee has made clear that, should downside risks materialise, it could consider a further reduction to bank rate.

It also has the option of making further asset purchases, a policy which Mr Weale’s research suggests “remain a practical means of pushing inflation up towards target”.