THE WORDS “interest rates” and “inflation” are often mentioned in the same breath. Low interest rates can lead to inflation and monetary policy makers often cite inflation as one of the key issues when deciding whether to increase interest rates. Looking at the US, Eurozone and the UK, inflation is certainly causing some concern.
Let’s be under no illusions regarding inflation. Even at today’s low rates of inflation (and I think these are likely to increase significantly over the next few years with oil price rises yet to filter through), over a 10-year period, you will see the spending power of your capital fall by as much as 30-40 per cent, if you do not invest to make sure that you are, at least, keeping pace with the rate of inflation in the geographical area you live in. It is still the greatest enemy of the retired individual, who invests so cautiously, that their capital does not maintain its spending power.
So, let’s take a look at the latest international news with regard inflation and interest rates.
United States
At its meeting in early May, the US Federal Reserve Bank raised its benchmark interest rate by a quarter point and signalled that it was more concerned about inflation pressure than slower economic growth.
This was the eighth increase for US interest rates since last June, when the central bank began a strategy of gradually reversing the cheap money policies it has previously used to combat the economic slowdown.
Some commentators, worried that inflationary pressures have begun to creep up, were hoping that the Federal Open Market Committee would raise rates faster, but the majority of economists had predicted the quarter point rise.
The Bank acknowledged the current economic soft patch, saying: “Recent data suggest that the solid pace of spending growth has slowed somewhat, partly in response to the earlier increases in energy prices.”
It also addressed concerns about inflation: “Pressures on inflation have picked up in recent months and pricing power is more evident.” While it said monetary policy remained “accommodative”, in contrast to its March wording, it left out a soothing declaration that higher energy prices had not significantly fed into increases in core consumer prices. This omission was taken as a signal that inflation is the chief concern.
Policymakers appear more worried about inflation than in March. Consumer prices are up 3.1 per cent over the past year and increased sharply in March. The Fed’s preferred measure of core inflation is up 1.7 per cent from a year ago. In March, it climbed at an annual rate of more than 2.3 per cent and, while the central bank has not set a goal for inflation, officials are not comfortable if core inflation is above 1.5 per cent a year.
As one economist concluded, “the clear signal remains that (a) rates are still too low, (b) inflation pressures are building and (c) the slowdown is nothing like severe enough to induce a pause in the rate hikes”.
Eurozone
Taking a different stance from the US Federal Reserve Bank, the European Central Bank (ECB) has only changed rates seven times since the start of 2001. The base rate stood at 4.5 per cent in May 2001, then declined to two per cent in June 2003 – where it has remained ever since.
At its May meeting, the ECB voted to keep rates at this six-decade low for the 24th consecutive month. Given the deteriorating Eurozone economic growth, this was not surprising. None of the 49 economists surveyed by Bloomberg had predicted a change and most expect rates to stay steady for the rest of the year.
In contrast to the US and the UK, the central bank repeated comments that it sees “no significant evidence of underlying inflationary pressure building up”, but added that, even amid slowing growth, “continued vigilance (on inflation) is warranted”.
The ECB is traditionally hawkish on inflation, which it is obliged to keep below two per cent. Its own preferred measure is 1.6 per cent, while the headline rate currently averages 2.1 per cent. Eurozone savers are, therefore, facing “negative” real interest rates, i.e. rates below the rate of inflation, but a rate rise in the current climate is highly unlikely.
Italy and Germany recently called for a rate cut to stimulate the economy, but President Jean-Claude Trichet refuses to be swayed by political pressure: “I said, a long time ago, that a decrease in rates was not an option and I can confirm that there is no change in this meeting. There is no contradiction at all between being faithful to our mandate and preserving an environment as favourable as possible for growth and job creation.”
United Kingdom
In April, most economists believed that inflationary pressure meant that an interest rate rise in June was likely. Figures published in mid-April showed that inflation had unexpectedly jumped in March, with the official basket of consumer goods on average 1.9 per cent more expensive than a year ago. It was the closest that inflation, as measured by the consumer price index, has come to the Bank of England’s target of two per cent, since the CPI was introduced as the new target at the beginning of the year. Both leading economists and the Bank of England appeared to be increasingly nervous about the prospects of long-term inflation in the future.
However, more recent data has pointed to a slowdown in consumer spending. The news on the economy appears to now outweigh inflation fears and the Bank kept rates at hold at its May meeting.
Some economists now believe that 4.75 per cent is the peak and that borrowing rates will have to fall soon; some analysts predict a rate cut by the end of the year.
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By Bill Blevins, Financial Correspondent,Blevins Franks
