This Thursday sees not only the MPC’s interest rate decision but also the publication of the latest Bank forecasts in its new Monetary Policy Report. It is likely to acknowledge that its previous forecasts were too pessimistic about the UK economy.
Good news, you might think. And so it is. Yet, other things equal, strong demand in the economy encourages higher prices and hence it will make it more difficult for inflation to fall back. So an upward revision to the Bank’s GDP forecast this week may well be accompanied by an upward revision to its inflation forecast. Hence the pressure on the MPC to continue raising interest rates.
One fly in the ointment is the state of the banking system. We knew that sharply higher interest rates would pose challenges for banks, but few people imagined the degree of interest rate mismatching that has gone on in the US banking system and hence the riskiness of many US banks’ positions. Moreover, falling prices for residential and commercial property on both sides of the Atlantic will weaken balance sheets.
I doubt whether such factors will stop the MPC from raising rates. The Bank genuinely believes that our banking system is well-positioned to absorb the consequences of higher interest rates. Mind you, as banks come under pressure, this should diminish their appetite to lend and anxiety about the state of the banks will also probably temper consumer and business confidence.
Even so, rates are likely to carry on rising to about 5pc. And it will surely be quite a while before the Bank can contemplate reducing them. It will want to see the underlying rate of inflation falling sharply towards the 2pc inflation target. And the key to that is going to be what happens to the rate of increase of average earnings.
With productivity growth still likely to struggle, to be consistent with 2pc price inflation, the rate of increase of average earnings needs to be about 3pc. The latest reading was almost 6pc and just under 7pc in the private sector. Clearly, there is a long way to go.
Roger Bootle is senior independent adviser to Capital Economics
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