Inflation and interest rates: the balancing act

We have seen interest rates rise five times in the last year, taking the rate from 4.5% to its current level of 5.75%. What are they (The Bank of England’s Monetary Policy Committee) trying to do? What are they responding to?

Their brief is to try and get inflation to hit the Government target, which is 2%. Inflation is measured as Consumer Price Index (CPI) which was introduced as the new measure in December 2003. The CPI is the main UK measure of inflation for macroeconomic purposes and forms the basis for the Government’s inflation target. It is also used for international comparisons.

When introduced in December 2003, CPI was a mere 1.3%. At that time the base interest rate was 3.75%. Inflation dipped as low as 1.1% in March 2004, yet the base rate was put up in February 2004 to 4%. By June 2004 inflation was up to 1.6%, and the interest rate had been hiked up twice to reach 4.5% in the same month. It seems that pushing up interest rates was having little effect on inflation at that time. But inflation did come down again, back to 1.1% by September 2004. That didn’t stop interest rates going up again as they had done in August 2004, to 4.75%.

In the following twelve months the base rate was left alone at 4.75%, but inflation began to creep up, from 1.1% in September 2004 to 2% in June 2005, and 2.4% by August, at which point the MPC acted again. They might have been expected to increase the rate, but instead they took it down again – back to 4.5% in August 2005. It appears a strange decision, but in fact inflation peaked at 2.5% the following month before coming down to a low of 1.8% in March 2006. Inflation then went up by 0.2%, 0.2% and 0.3% in consecutive months to reach 2.5% by June 2006. The MPC reacted in August, the first of the current round of rate rises, taking the rate to 4.75%. In November they added another quarter point, but by December inflation had reached 3% - the first time at this level for the CPI.

Inflation fell in January 2007 to 2.7%, but the MPC weren’t prepared to leave things to chance and up went the base rate again, to 5.25%. However, it seemed throughout the early months of 2007 that the rate rises were having little impact on the rate of inflation, which peaked at 3.1% in March. That led to almost panic by the MPC who pushed the rate up again in May to 5.5%, and some of the committee wanted another quarter point rise in June. They did get their way a month later as the rate went up to 5.7%, its highest level since March 2001. Meanwhile inflation was down again to 2.5% in May, and June’s figures are eagerly awaited. The last time inflation was as low as 2.5% was October 2006 (2.4%) and the interest rate was 4.75%.

The highest rate reached by the base rate was 17% in November 1979. More recently it was at 14.875% in October 1989. The lowest rate during the 1980s was 7.735%. The record low level for the bank rate has 2%, which was last reached twice in the 1930s.

Other measures of inflation include the Retail Price Index (RPI) which stood at 4.3% in May 2007; the RPIX which excludes mortgage interest payments and is used to calculate income-related benefits (also known as the underlying rate) – this was 3.3% in May 2007. The record high for inflation since 1948 was during 1975 when RPI averaged 24.2%, peaking at 26.9% in August. The record low for inflation since 1948 was in 1959 when RPI averaged 0.6%, including four months’ deflation.

The MPC has the job of pushing inflation to the 2% target. Sometimes they have to get ahead of it to push it down, and sometimes they have to keep interest rates stable while other factors manoeuvre inflation. The problem they have is that there are so many other influences which they can’t control. For example consumers are borrowing more on credit than they have ever done before. This is a shift in consumer attitudes which seems to be buy now – and hang the consequences as Britons pursue a celebrity life style that is really beyond their means.

Some of the figures discussed above now appear inconceivable and it is to be hoped that we never see inflation of around 25% again. Nevertheless all these figures and this discussion serves to emphasise the cyclical nature of finances. Figures go up; figures go down. Trying to keep them in once place would be the same as trying to stand on a ball – you have to keep making minor balancing adjustments to achieve it – and occasionally you fall off.