Above-target inflation and a squeeze on living standards are likely to be features of the British economy for years to come following sterling’s sharp depreciation since the Brexit vote, according to a blog by Bank of England staff published ahead of next week’s monetary policy meeting.
The staff research suggests that currency depreciations in practice have almost double the effect on raising prices than the central bank’s main models predict, even if there is no pass through to wages and domestic costs.
The research, published on the BoE’s Bank Underground blog, will give more ammunition to the hawks on the Monetary Policy Committee, who want to increase interest rates to keep the inflation forecast close to the 2 per cent target in two to three years’ time.
The MPC will meet next week and announce whether to raise rates by a quarter point to 0.5 per cent, which would mark the first tightening of monetary policy for a decade.
Recent statements from committee members suggest the vote on the nine-strong MPC will be close. Two members have already voted for rate increases, and in September two more put themselves in a group committed to raising rates “in the coming months”. In June Andy Haldane, the bank’s chief economist, called for a rate rise in the second half of the year.
Three others on the committee have either not given a clear steer or suggested it is too early for rate rises and one member has remained an enigma by saying nothing.
Financial markets put a high probability on a rate rise because it appears there is a majority of at least five — Mark Carney, Mr Haldane, Gertjan Vlieghe, Michael Saunders and Ian McCafferty — leaning towards action in November. A simple majority is all that is required.
The new research examines whether prices for the same goods and services can differ between the UK and European countries over long periods.
After including the sterling exchange rate in a model that questions how much gravitational force there is between prices in Britain and on the continent, BoE economist Alex Tuckett concluded that prices in European countries are “an excellent conditioning variable for UK prices”.
“The influence of the exchange rate goes beyond the direct cost channel, and lasts for years not quarters,” he said. “In the long run, a 10 per cent fall in the value of sterling relative to the euro increases UK prices by 3.8 per cent,” almost twice the standard BoE assumption of 2 per cent, the research added.
“I find EU prices have much higher explanatory power for UK prices than domestic cost pressures,” he concluded, adding, “the effects of exchange rate changes last longer, but build more slowly than commonly assumed.”
The research suggests the MPC could respond to higher inflation for longer in one of two ways. Either the committee could worry that it was likely to miss its target with too high inflation for a very long period of years and tighten policy in an attempt to bring it down. Or it could take a more relaxed and flexible interpretation, concluding that inflation will come down eventually.
The BoE will announce its interest rate decision on 2 November.