Bank of England Needs Shock Move to Tame Prices - By Matthew Lynn

"The trouble is, once an inflationary psychology takes hold, rates go higher and stay higher. In the decade from 1980 to 1990, borrowing costs never went lower than 7.5 percent, and climbed as high as 17 percent.

The U.K. may be about to repeat that dismal experience. The official inflation figures are now widely discounted because they don't reflect everyday reality. The Office for National Statistics already offers an online ``personal inflation calculator'' that allows you to work out your own inflation rate. "


Bank of England Needs Shock Move to Tame Prices

By Matthew Lynn
June 5, 2007
Source

June 6 (Bloomberg) -- Where will U.K. interest rates peak? Most people in the market say it is somewhere between the current 5.5 percent and 6 percent.

They are kidding themselves.

When the Bank of England's Monetary Policy Committee begins its two-day meeting today, it should consider a shock half-point move straight to 6 percent. Meanwhile, the markets should be thinking about rates peaking closer to 7 percent.

The U.K. economy appears to be immune to the mild anti- inflationary medicine dished out by Governor Mervyn King.

An inflationary psychology may be taking root in the U.K., just as it did through the 1970s and 1980s. Experience shows that once that happens, you need a big stick to beat it.

``The danger that inflation could get out of control is increasing,'' Roger Bootle, an economic adviser to Deloitte & Touche LLP, said in the minutes of the Shadow MPC, a group of economists who hold their own monthly discussion on interest rates. ``The MPC needs to raise rates to a level that will have a real impact on borrowers and lenders.''

Most economists say the Bank of England will leave rates on hold when it makes its announcement tomorrow. A Bloomberg News survey found four analysts predicting a rate increase this week, compared with 57 forecasting that borrowing costs will stay put.

The MPC will ignore the inflationary pressures at its peril. The key rate has risen from 3.5 percent in 2003 to curb house values and consumer prices. And it has had no effect.

Real-Estate Boom

House-price increases may have slowed slightly. Yet, the Nationwide Building Society says prices are still advancing 10 percent a year. Measured by anything other than the standards of the recent boom, that is still a very fast rate. A stable property market in the U.K. would mean homes appreciate by an annual 3 percent -- much less than the current pace.

If the Bank of England wants stability in the real-estate market -- and its rhetoric suggests it does -- it is still a long way from achieving that.

Last month, a quarterly survey of 89 retailers by the Confederation of British Industry found 47 percent reporting higher prices in May from a year earlier, while only 14 percent said prices declined. The net balance of 33 percentage points was the highest since May 1998.

Not much sign of those interest-rate increases starting to bite there either.

Another CBI survey, released on May 24, showed U.K. manufacturers were more confident about their ability to raise prices than at any time since 1995.

Inflation Psychology

And why shouldn't they? The British economy remains buoyant with faster-than-expected growth of 2.9 percent in the first quarter; the pound is strong, gaining almost 7 percent against the dollar in the past year; and the unemployment rate of 2.8 percent in April was the lowest since November 2005. The government continues to spend money like crazy. It makes sense to edge your prices up slightly -- your profits will rise, and the chances are that your customers will pay up.

The trouble is, once an inflationary psychology takes hold, rates go higher and stay higher. In the decade from 1980 to 1990, borrowing costs never went lower than 7.5 percent, and climbed as high as 17 percent.

The U.K. may be about to repeat that dismal experience. The official inflation figures are now widely discounted because they don't reflect everyday reality. The Office for National Statistics already offers an online ``personal inflation calculator'' that allows you to work out your own inflation rate.

Price Spiral

If you happen to spend all your money on Polish builders and Korean DVD players, your inflation rate is probably even lower than the official figure. For most people paying big mortgages on exorbitant house prices, with rising utility bills and property taxes, the inflation rate will be much higher.

Once people become suspicious of the official figures, and once they start estimating inflation of 6 percent annually in their own personal calculations, then you are on the way to an inflationary spiral. Wages and prices are pushed up because the expectation is that everyone else will do the same.

You could argue that the medicine hasn't had time to work yet. It takes a year or more for interest-rate increases to feed through to the economy. Against that, with oil prices surging again, and booming commodities pushing up the cost of imports, inflationary pressures will worsen in the year ahead. April money supply grew 13.3 percent, another reason for the central bank to raise rates again.

The Bank of England has been tapping its foot on the brakes. Yet the car hasn't been slowing down. That suggests the brakes aren't working, or the engine is too powerful. Either way, tougher measures are needed to bring it back under control.

That means interest rates will have to go much higher, and the sooner the Bank of England gets there, the better.

(Matthew Lynn is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: Matthew Lynn in London at matthewlynn@bloomberg.net .
Last Updated: June 5, 2007 19:26 EDT