Interest rates on hold despite inflationary fears

OPINIONS on the short-term economic outlook have not been this confused in a long time, and the confusion has rarely had such longevity. The public mood seems to swing from positive to negative depending on what particular number is published that day. But two recent indicators hint at the direction of interest rates in the coming months and the general condition of the economy.

The current debate has focused either on growth or inflation, either worries that activity is still weak or that prices are rising too quickly. Those more concerned with inflation favour higher interest rates to nip the price pressures in the bud, whereas those still unconvinced about the pace of growth argue that higher interest rates would undermine recovery. This uncertainty about interest rates is damaging for confidence in both the personal and corporate sectors. The picture seems at last to have become a little clearer.

There was probably a huge sigh of relief at the Treasury when the first cut of first-quarter growth was estimated at 0.5 percent. This reversed the fall in fourth-quarter 2010 GDP and indicated that the recovery had not been derailed. It did no more, however, than reclaim the ground that had been lost in the weather-affected final months of last year and, taking the two quarters together, pointed to an economy still in a fragile condition. Activity clearly still needs some encouragement - particularly from continued low interest rates.

A week earlier, the Consumer Price Index (CPI) showed a fall in the annual rate of inflation from 4.4 percent to four percent. However, April’s CPI figures released on 17 May returned to 4.5 percent. The inflation hawks feared that the rise in consumer prices would have a knock-on effect on wage settlements and the UK would get caught up in a wage-price spiral. The doves, on the other hand, argued that inflation was either imported (commodity and energy prices) or government-induced (excise duties and VAT) and higher interest rates were more likely to damage growth than curb inflation.