Many economic analyzes and comments focus on the high that will be the peak of inflation. This is an important issue. But I don’t think it’s as important as what happens next.
From an optimistic point of view, the inflation rate will fall quite easily without many additional incentives from the Bank. But I have a less benign view: even though inflation will drop from its peak, it will not easily return to the 2pc target without much extra pressure.
The bank has insisted it has no power to curb or even reduce supply-side inflationary pressures, including global energy prices. This is a bit of an exaggeration, but just a little bit. It could be said that the maximum inflation rate is out of the hands of the Bank.
But this is not true for inflation beyond the peak. Of course, even if energy prices do not fall, inflation is expected to decline quite rapidly, as this year’s sharp rises in energy prices fall out of the annual comparison. However, the extent to which inflation is falling will also be influenced by internal economic factors: the state of aggregate demand, the level of wage growth, the expectations of companies about future inflation, and exchange rates. The Bank’s performance – and its reputation – can have a key impact on these issues, especially the latter.
There is no need for UK interest rates to be fully involved in the general rise in official interest rates that is taking place in almost every world. But if they don’t, the exchange rate will tend to suffer.
Recently, there have been many frothy and unjudgmental comments suggesting that the pound has become a kind of banana republic currency. This is nonsense. It is true that the pound sterling has fallen by almost 9% against the dollar since the beginning of the year, but this is mainly due to the fact that the US currency has been strong. Compared to the euro, it is only down 1.8%. In addition, the pound is currently in the middle of the negotiating range that has been in place since the 2016 Brexit referendum.
Note that if the Bank lags far behind in rising interest rates, the pound could fall a little further. This would make it even more difficult for the Bank to return inflation to its target. As a general rule, if the pound falls by 10 per cent, this will tend to raise prices directly between 2 and 3 per cent, spread over several years.
However, as we have seen in terms of the effects of rising energy prices, this is only part of the process. If the inflationary momentum, instead of being accepted and absorbed, is transmitted in the form of higher generalized increases in prices and higher wages, then this one-time jump in the price level may end up being a higher rate of inflation. permanently.
Despite all the criticism of the Bank over the last few months, including mine, no one should pretend that their job is easy. The Bank is clearly concerned that the economy is already slowing sharply and that raising interest rates too quickly could cause the economy to fall into recession.
Assessing the economy and trying to establish policy accordingly is like shooting at a constantly moving target. Several pieces of important economic data are released this week that may justify the Bank of England’s caution about interest rates.
There is unlikely to be any support for the most important data set, namely the release of Wednesday’s May inflation figures. I suspect the rate may increase from 9% to about 9.2%. But I am willing to surprise myself with a higher figure.
It strikes me that inflation in the U.S. rose sharply in May, and that was certainly a major factor in pushing the Fed to impose a sharp rise in interest rates.
On Friday we will have some more clues about the state of the real economy from the release of the latest retail sales figures. I suspect they will show a sharp drop in the month – the third drop in four months. On the same day, we will also see consumer confidence figures, and the same logic applies. They can be very weak.
If these figures turn out this way, this would strengthen the Bank’s caution and moderate growing criticism of its performance. It needs a lot of support from somewhere. Its credibility is now heavily compromised. This could be costly.
Roger Bootle is President of Capital Economics