Inflation is rising.In January it reached 4% and the pressure on the Bank of England to raise interest rates is increasing.
But Mervyn King, the Governor of the Bank of England claims the drivers for the current inflationary pressure are not internal to the UK, instead they are driven by increasing commodity prices especially fuel and food.
So how can increasing the interest rates do anything to stem the price rises?
Before I can even attempt to answer this question (or indeed pass on any wisdom gained by attending lectures by Cranfield’s Joe Nellis and John Glen) it is helpful to mention that the Nobel prize winning economist Milton Friedman believed that “inflation is always and everywhere a monetary phenomenon”.
But what does that mean to us mere mortals? Inflation is caused by “too much money chasing too few goods” and this is true on a worldwide scale even if the UK is teetering on the edge of a double-dip recession.
By increasing interest rates the Bank of England would be effectively reducing the propensity of people to borrow and spend money and this would lead to a reduction in the over-demand for goods.
The confusing thing is that the Bank of England has only just stopped its quantitative easing programme which was designed to pump more money into the country’s money flows and create the consumer demand that will drag the country out of recession.
But as with most things there is a time lag, and the effects of quantitative easing on inflation are expected to be felt about 18 months after the programme started!
So despite the country experiencing ‘negative growth’ in the last 3 months of last year and a reduction in willingness to spend caused by the VAT increases, inflationary pressure is expected to grow further due to the increased money supply.
The crucial question is really not whether interest rates will be raised, or indeed when, but what effect the inevitable increase will have on the country’s growth.