Business Outlook: The horns of the Bank's dilemma
Tuesday 20 January 1998
If greater domestic inflationary pressure in the UK, bringing the prospect of a widening interest-rate differential compared with other countries, were the only explanation for the high exchange rate, then the Bank of England could lance the boil by getting rates quickly to their peak.
Unfortunately, it is only one reason among several, and the other influences can not be reversed so easily. They include the dollar slipstream effect and the more recent hedging against EMU effect. Both could keep sterling at painful levels.
While industry exaggerates the pain, the sustained exchange rate appreciation is probably starting to take its toll on Britain's balance of payments. This will slow growth overall, but not necessarily domestic demand.
Here is the Bank of England's dilemma. Does the external slowdown outweigh the domestic inflationary push from wage growth and consumer spending? Inflation is very likely to pick up again later this year just because of the lagged effects of pre-election laxness on interest rates. But how much more damage on the inflation front would be done by not raising rates any further now?
This is obviously a difficult judgement for members of the Monetary Policy Committee to make. The chances are that this year will see both weaker growth and rising inflation, with relatively little the Bank can do about it. The Bank is also handicapped by a very optimistic inflation forecast, which means that once inflation begins to overshoot it, the MPC will find it difficult to justify not raising interest rates even if this is thought the wrong thing to do.
Perhaps the other economic figures out this week - retail sales and GDP - will settle things, but analysts are too prone to seeking a definitive answer from a single statistic.
It is an intrinsically hard call to make. Raising rates by a quarter point in February and announcing that they have probably reached their peak might help take some of the steam out of sterling, though this plainly didn't do the trick for anything other than a brief period it was last tried in the summer.
Perhaps the best policy would be for the MPC to adopt a wait and see approach after all.
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