Will the Bank of England raise rates next month?

The pound is continuing to slide, as traders ponder what yesterday morning’s drop in inflation means for UK interest rates.

Sterling has now fallen by a whole cent against the US dollar, to $1.419. It’s also down 0.7% against the euro, to €1.147.

At the start of this week, a May rate hike looked to be nailed on. But the news that the Consumer Prices Index has fallen back towards the Bank of England’s 2% target is prompting a rethink.

Professor Costas Milas of the University of Liverpool suspects that the BoE’s Monetary Policy Committee might vote for a rate hike, to 0.75%.... but he also thinks it would be a mistake. He told The Guardian: “Despite the drop in inflation, I still suspect MPC members might hike.

“After all they have done it in the past: From my database, MPC members voted in July 2007 for a hike (to 5.75%) despite CPI inflation ‘dropping like a stone’ by recording three (!) successive falls from 3.1% in March 2007 to 2.8% in April, to 2.5% in May and to 2.4% in June 2007!

“But, they shouldn’t as my colleague Michael Ellington from Liverpool University and I show in a brand new paper that interest rate hikes are more powerful in reducing inflation when inflation exceeds 3%.

Far from a done deal next month’s decision!

However, Andrew Sentance, senior economic adviser at PwC, argues that the BoE should raise borrowing costs, as inflation is likely to remain above target this year.

“Though the impact of a weakened pound appears to be drop- ping out of the inflation numbers, three other factors are likely to exert an offsetting upward pressure on the pace of price increases. Productivity growth remains sluggish, with GDP rising not much above the rate of employment growth. Wage increases are also picking up - and could easily reach 3%per annum in the second half of this year.

In addition, a buoyant global economy is likely to continue to push up food and energy prices, with the oil price now already above $70/barrel.

“The Bank of England should not therefore treat this latest fallback in inflation as a dovish signal for interest rate policy. The MPC’s approach has normally been to look through short-term fluctuations and focus on the longer term influences on the inflation outlook. With unemployment at its lowest level since the mid-1970s, continued UK economic growth, a strong global economy, and inflation likely to remain above-target, there is still a very strong case for a rise in interest rates to 0.75% at next month’s MPC meeting.”

So, next month’s Bank of England meeting - on 10th May - will be rather exciting....