Why the MPC should hold.

In my ‘O’ level in economics there are broadly are two causes of inflation – Cost-push inflation and Demand-pull inflation.

These are pretty self explanatory – cost-push being increased prices of raw materials and demand-pull being increases in demand allowing the market to set a higher price.

The MPC has interest rates as a tool to keep inflation in check.  Interest rates affect consumer spending and so put a kerb on consumer demand hence mitigating demand-pull inflation.

However, it is fairly plain to me that we are not suffering demand-pull inflation – the UK retail sector is not exactly in rapid growth.  According to the office of national statistics -

“Over the period February 2011 to March 2011 the retail sales volumes increased by 0.2 per cent and the value of retail sales increased by 0.1 per cent.”

Our current inflationary woes seem to be caused mainly by high oil and commodity prices and historically weak sterling.  Raising interest rates at this point would, in my opinion:

1. Stifle the current recovery – particularly in weaker UK regions such as Northern Ireland which are not yet out of recession,
2. May strengthen sterling leading to decreased competitiveness of UK exports,
3. Not reduce inflation which currently seems to be mainly cost-push

So far I’ve not mentioned the other influencer – monetary policy.

Monetary policy is about how much money is in circulation.  By putting more money in circulation through “Quantitative Easing” (QE), the Bank of England made the pound in our pocket worth a bit less – result – inflation.

Now that QE has stopped, I would expect the value of the pound in our pocked to stabilise.

So, on balance, the decision for the MPC on 4’th and 5’th of May should be simple, hold firm on interest rates.  I would expect this to remain the case until we see significant demand-pull inflation.

I would also expect inflation to continue to fall away over the coming months as cost-push inflation falls as commodity and oil prices stabilise or fall.