Interest rates and inflation: An international comparison

By Paul Hunt, Managing Director of Phoebus Software,

The Bric countries are building up their interest rates and tightening their macroeconomic policy.  In June, Brazil’s central bank raised interest rates for the fourth time this year.  The Bank of Russia raised its key policy rate twice in the six weeks following the beginning of May.  The Reserve Bank of India must have raised its key lending rate ten times since March 2010, while over the course of 2011, the People’s Bank of China has raised its reserve requirement ratio more than five times.

In each case — apart from Russia, which has been suffering from capital outflows — the move is a response to inflation remaining stubbornly above target.  Chinese consumer prices inflation is at a three-year high, while on India’s chosen measure, inflation now tops 9 per cent.

The question is whether this inflation is due to a demand shock or a supply shock.  In China’s case, it is the latter when it comes to rampant food prices.  In India, it is a similar situation, although with non-food items.

As yet, these concerns do not appear to be hitting demand for riskier assets in emerging markets, despite the poor showing of Shanghai’s stock market — second only to that of Athens — so far this year.  That is probably not a bad call: China’s recent robust industrial production and retail sales data point to the People’s Bank of China engineering a soft landing and, compared with the lacklustre returns available in the US and UK, investors may judge a little inflation risk to be perfectly tolerable.

Should the UK be following the example of the Bric countries?  Some of the members of the Monetary Policy Committee clearly think we should be, as a number have been voting for rate rises.

In doing so, they are failing the UK’s lending industry.  When you look at the people involved, it’s clear why.  They might know how to teach economic theory but they have no practical experience of the lending market.  The Monetary Policy Committee’s nine-man team only has a combined total of 112 years experience between them, at the Bank or in lending.  Between them, our nine most senior employees have over 290 years experience in lending, consultancy, or in software development for lenders.  On average, that’s 32 years each – more than double what the Monetary Policy Committee can muster.  We regard experience as an extremely valuable commodity – the worrying thing is that the Monetary Policy Committee doesn’t seem to be operating along the same principles.

Take Monetary Policy Committee hawk Martin Weale.  His experience may make him an expert on Malawi’s office of national statistics having worked there as an Overseas Development Institute Fellow.  But he doesn’t know what it’s like at the coalface of UK lending.  That’s a recipe for disaster.  Andy Hornby had no previous banking experience when he was given control of HBoS.  He was a very successful retailer, but what he knew about the finer points of banking, you could write on the back of a postage stamp.  Matt Ridley was Chairman of Northern Rock when it had to be nationalised.  Apparently, editing magazines didn’t help him recognise the risks of the bank's financial strategy when he oversaw the board.  The Monetary Policy Committee should have learned from those painful lessons.

Fortunately, it appears The Governor of the Bank of England doesn’t think we should be following the example of the Bric countries.  Part of Mervyn King's Mansion House speech in June was a defence of the Bank of England's refusal to raise interest rates despite continued above-target inflation.  In a nutshell, the Governor said the UK had been importing inflation, which an interest rate rise would not reduce, while domestic inflation showed few signs of increasing.

The positive employment data we’ve seen of late supports that case.  It shows underlying earnings growth is just 2 per cent – less than half the prevailing rate of inflation as measured by the consumer price index.  Plainly, the extended period of higher price rises has not seen workers negotiate higher salary increases – at least not successfully.

As long as that remains so, the Bank of England's Monetary Policy Committee will not feel uncomfortable holding the cost of borrowing at its record low of 0.5 per cent.  Still, the fact that earnings growth lags inflation is a mixed blessing: it means the squeeze on household incomes, which is doing so much damage in consumer-facing parts of the economy – most of it, that is – is continuing to tighten.