Bank of England Faces Difficult Interest Rate Decision

Less than a week after holding the benchmark lending rate at 0.5 percent, there is talk in some quarters that the Bank of England will soon be forced to reverse its policy of record low interest rates. The suggestion is that inflationary pressures present in the economy, will leave the Monetary Policy Committee no option but to hike interest rates in order to ease the rate of expansion.

At first glance, the argument seems reasonable as the latest growth report shows that last month, the economy grew at an annualized rate of 3.7 percent. Compare this result to the inflation target of 2 percent, and you can see that inflation in the British economy, is nearly double the target rate. A closer look however, reveals that things may not be so simple and straight-forward.

Like most developed countries, England is still dealing with the lingering effects of the global recession. During the worst of the recession, the government pumped billions into the economy as part of its stimulus program, while slashing interest rates to boost consumer lending. Both moves were attempts to ensure money was flowing as freely as possible within the economy. This is standard operating procedure during a recession and was duplicated by central banks in all the major economies.

This past recession was particularly troublesome, but with the economy showing positive signs, the Monetary Policy Committee is keeping its foot planted on the interest rate accelerator. This is a clear signal that the Bank of England remains committed to an expansionary monetary policy.

This seems at odds however with the view of Britain’s new Prime Minister who views inflation as a more immediate concern. David Cameron no doubt sent markets into a slight wobble when he voiced these thoughts just prior to the last rate announcement.

“We have seen a slightly worrying increase in inflation in recent months, noted PM David Cameron. “So, interest rates will be set to control inflation.”

There are a couple or problems with Cameron’s comments, not the least of which, the Bank of England is the source of the country’s interest rate policies. Still, 3.7 percent is well above the target rate, so why is the Bank of England not following Canada’s recent example and increasing interest rates?

The answer lies in the fact that Canada is expected to lead the G8 in growth for the remainder of the year; for the UK on the other hand, the second half of 2010 is shaping up to be a bit of a bust.

Spare Capacity Means Growth Could Falter

In its broadest terms, capacity refers to the amount that can be produced within the economy if everything, and everyone, is operating at full potential. Full capacity is theoretical at best, but the greater the gap between “full” capacity and excess or spare capacity, the weaker the overall economy.

With respect to the UK, the prevailing belief is that growth in the British economy, is nearing a peak. Despite this, a great deal of excess capacity still remains in the economy as evidenced by stagnant production numbers. Worse still, unemployment shows no signs of improving and hovers, stubbornly, well above 8 percent. Under these conditions, growth is expected to falter as consumers limit their spending to the essentials.

This is why few were surprised when the Monetary Policy Committee’s statement of last Thursday left rates unchanged at 0.5 percent. Comments from Stephen Boyle, head of group economics at the Royal Bank of Scotland, confirm that little appetite exists in the market right now for a rate increase.

“No change [in the interest rate]. No surprise. Inflation is well above target but real wage growth is negligible and people don’t expect prices to take off,” Boyle said, adding, “Rates are going to stay where they are at least until the end of the year.”

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