Inflation and Interest Rates in 2008

Many had predicted the fall in house prices would precipitate significant cuts in interest rates to bolster the economy. However, it appears the UK may be experiencing the worst of both worlds. Not just slower growth but also higher inflation.

Factory gate inflation (the price of goods leaving the factory at wholesale prices) is at a 15 year high. This usually feeds through into higher consumer price inflation.

Rising food, energy and oil prices. Growth in demand from China and India plus constraints on supply mean that oil prices and food prices have been rising, this increases the general cost of living

Maybe house prices will not fall after all. A prediction for house prices today suggests that house prices may rise by 3% this year.

Another factor is the devaluation in the Pound. Since autumn the Pound has fallen 10% on its trade weighted index. A devaluation makes imported goods more expensive and boosts Aggregate Demand increasing inflationary pressure.

Although UK inflation remains very close to the government’s target of CPI = 2% (2.1%) any rise in inflation would make it more difficult to cut interest rates. Sir John Gieve of the Bank of England said:

That is being amplified in the UK by a fall in sterling and is now coming through in our food, petrol, gas and electricity prices. These are likely to raise our inflation rate well above target in the coming months, at a time when short-term inflation expectations remain uncomfortably high,”

A cut in interest rates would also weaken the value of the Pound further, good for exporters but may contribute to the problem of inflation