BOE economist says interest rates may have to rise as prices fall

By Philip Aldrick and Lucy White

The Bank of England Chief Economist Huw Pill said officials may need to raise interest rates even as inflation falls to prevent resurgence in prices caused by households and companies trying to claw back their lost income.
 

Inflation is set to drop sharply from the current 10.4% level in the coming months due to lower energy prices and base effects, as last year’s sharp price jumps are not repeated.

But policy makers need to be alert to the risk of “a self-sustaining momentum in headline inflation which justifies a monetary policy response, even as the initial impulse from the energy price recedes,” Pill said, according to the text of a speech he’s due to deliver Tuesday night in Geneva.

The BOE has raised rates at 11 consecutive meetings from 0.1% to 4.25%, the fastest tightening cycle since the late 1980s, and market pricing suggests it is close to pausing, with one more quarter point increase expected.

However, Pill argued that further action may be necessary if there is evidence of “inflation persistence.” UK households are only just emerging from the steepest fall in living standards since the 1950s, workers are striking to drive up pay, and private sector wage settlements are the highest they have been in decades. 

Pill said policymakers need to understand what will drive inflation in 12 to 24 months, not the immediate outlook, and officials should not draw false hope from falling headline inflation as long as underlying pressures remain strong. 

“We should recognize that persistent deviations of inflation from target, even if stemming from what are fundamentally a series of transitory shocks, might prompt changes in behavior that generate more long-lasting inflationary dynamics,” he said.

“Greater intrinsic persistence of inflation would justify a stronger tightening of monetary policy.”

He added that households and businesses may try to recover the hit to real incomes and profits over the past year and half even as energy costs stabilize. 

“That element of inflation driven by firms’ and households’ attempts to avoid the real cost of higher energy prices is likely to persist as long as energy prices remain high, not just while energy prices are rising,” Pill said. “This is what creates the potential for the second round effects.”

Those second round effects may result in “potential persistence of domestically generated inflation.”

The remarks stopped short of indicating how Pill would vote when the Monetary Policy Committee meets next in May. He said he’d look at economic data and the bank’s forecasts at that meeting to decide and that he won’t give any guidance on the likely outcome.