UK Interest Rates

According to experts, the concern surrounding wage-driven inflation must be addressed by the Bank of England by setting an interest rate target of 5.75% to be achieved by mid June. It is expected that during May, interest rates are likely to increase from 5.25% to 5.5%. However, according to the National Institute for Economic and Social Research, a more substantial increase is required. They argue that the increase will help counteract the alarming rise in the UK’s Retail Price Index (RPI), which has reached its highest level for 16 years at 4.8%. RPI provides an indication of inflationary behaviour by measuring the changes in the cost of a fixed basket of retail goods within the UK. But where does the problem lie?

The fundamental issue with a rise in RPI inflation is that this will inevitably lead to employees demanding higher wages to support increased living costs. The National Institute for Economics and Social Research advocates that as much as a half of a percentage increase in the base rate of inflation will help to counteract the problems associated with increasing RPI inflation, hence the proposed target of 5.75%. How do rising interest rates lead to falling inflation? Essentially, rising interest rates will lead to a decline in domestic consumption, investment, and exports, resulting in lower aggregate demand and therefore lower prices.

The government however, generally favours using the Consumer Price Index (CPI) as the main tool in determining necessary changes (if any) to the rate of interest. Currently, CPI is at an all time high of 3.1%, which is considerably higher than the Bank of England’s desired target of 2%. It is the fundamental objective of the Bank of England to achieve a 2% inflation target, and thus, as the Governor of the Bank of England has recently stated, we can expect a significant fall in inflation rates over the coming months, which would obviously lead to expectations of increasing interest rates.

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2 May 2007 | Banks, General Finance | Comments