The Bank of England will probably increase interest rates this year by the most since it gained independence in 1997 or face losing its credibility, Societe Generale SA Chief U.K. Economist Brian Hilliard said.
“There is an urgency there, if the market starts to worry that we are going to lose the credibility of the target,” London-based Hilliard said in a telephone interview today after changing his rate forecast late yesterday. “To start the ball rolling, they need to do something that is more substantial.”
He sees policy makers raising the benchmark interest rate by 0.5 percentage point in August and again in November. That compares with a previous prediction that they would leave the rate at a record low of 0.5 percent until the second quarter of 2012. The central bank has never increased the rate by more than 0.25 percentage point. BNP Paribas SA and Citigroup Inc. revised their Bank of England interest-rate forecasts today.
U.K. central bank officials’ concern about inflation mounted after the rate rose further above the government’s 3 percent limit in November, minutes of their December meeting showed. Former policy maker David Blanchflower said today that a rate increase this year would be Chancellor of the Exchequer George Osborne’s “worst nightmare” as government spending cuts to reduce the deficit threaten the economic recovery.
While the deepest spending cuts in a generation may curb domestic demand, accelerating inflation has fueled speculation the bank’s next move may be a rate increase. The Confederation of British Industry said on Dec. 20 policy makers will probably raise interest rates within six months, even as economic growth is forecast to remain “very sluggish.”
Inflation quickened to 3.3 percent in November and the central bank forecasts it will remain above its 2 percent target through 2011. The Monetary Policy Committee has split three ways in the past three months on whether to raise rates to combat price pressures or add stimulus to aid economic growth.
“There is validity in the bank’s view that there are significant risks to growth especially as the coming fiscal year will be the key year for the tightening of fiscal policy,” Hilliard said. “But I think the bank risks losing credibility on its anti-inflation stance.”
Hilliard, a former Bank of England official, said that while half-point increases this year will be needed to normalize interest rates because of the “massive” policy loosening during the recession, the path of increases won’t be constant. He also said an interest rate of 1.5 percent by the end of the year would “still be extremely, extremely loose.”
Posen Versus Sentance
Policy makers left the benchmark rate unchanged and kept the emergency bond plan at 200 billion pounds ($309 billion) on Dec. 9. Adam Posen kept up his demand to increase the stimulus by 50 billion pounds and his colleague, Andrew Sentance, voted to raise the interest rate for a seventh month.
The central bank will leave the size of the bank’s bond holdings unchanged on Jan. 13, according to all 39 economists in a Bloomberg News survey. They will also keep the rate at 0.5 percent, all 61 economists in a separate survey said.
BNP Paribas economist Alan Clarke brought forward his prediction of when the central bank will begin to increase its benchmark rate. He expects policy makers to raise borrowing costs by 0.25 percent in August, compared with a previous forecast of the second quarter of 2012.
The increasing threat of faster-than-targeted inflation prompted Citigroup to change its forecast as well. Citigroup economist Michael Saunders now sees policy makers raising their benchmark interest rate twice by 0.25 percent to 1 percent by the end of 2011, compared with a previous prediction of only one 0.25 percent increase.
“For the last two years we’ve had four times as many upward surprises than downward surprises on inflation and it’s beginning to wear a bit thin, the argument about temporary factors,” London-based Clarke said by telephone. “The bank will have to hike to regain credibility and avoid inflation expectations getting completely out of control.”
Hilliard said that while risks to economic growth remain, they will be outweighed by inflation concerns as price-growth expectations increase. Bank of England Deputy Governor Charles Bean said on Dec. 13 that the strength of inflation has increased the risk to price expectations and there may also be less slack in the economy than previously thought.
“The thing that worries me most in that is medium-term inflation expectations,” Hilliard said. “The Bank of England’s own survey has expectations out to two years and also out to five years, and those are rising and well above target.”
Officials have said that above-target inflation is partly due to one-off effects from oil prices and a sales-tax increase.
Even without the effect of value-added tax, “the underlying rate of inflation is still unacceptably high,” Hilliard said. “We have higher pressures coming from energy, from food, from clothing. You can’t dismiss them all as one-off shocks, or you have nothing left to target or control.”