Interest rate to stay on hold in 2010
The interest rate is likely to remain on hold throughout 2010 despite the fact that inflation increased in October for the first time in eight months - and is expected to continue to rise in the month ahead.
The Consumer Prices Index (CPI) – the official measure of inflation – rose to 1.5% in October from 1.1% the previous month. The Office for National Statistics, which publishes the monthly inflation figure, says the main upward drivers have been transport and food costs. Overall transport costs have risen by 3.5% year-on-year.
Experts predict that annual inflation will continue to rise in the coming months, with the return of the 17.5% rate of VAT in January helping to push up the cost of living. Inflation is expected to rise beyond the Bank of England’s 2% target in 2010, and even move above 3%.
But this is not the major concern, says Charles David, senior economist at the Centre for Economic and Business Research: “As bank lending remains weak and fiscal tightening kicks in, we expect interest rates to remain on hold through 2010.”
A rising rate of inflation is often caused by too much money in circulation, so there have been concerns that the government’s quantitative easing programme – the creation of new money – will cause inflation to soar in 2010. So far, £200 billion of new money has been injected into the economy by the central bank.
Jonathan Loynes, chief European economist at Capital Economics, says the “vast amount of spare capacity in the economy” - basically, weak economic growth - will help prevent quantitative easing from creating hyperinflation.
“Remember that headline inflation went above 5% back in 2008, with no real ‘second round effects’ on wages and inflation expectations,” he adds. “And the economy was in a much healthier state back then. In short, no need to panic.”
Invented by a Frenchman in 1954 and ironically introduced in the UK on 1 April 1973, VAT is an indirect tax levied on the value added in the production of goods and services, from primary production to final consumption and is paid by the buyer. Its levying is complex, with a number of exemptions and exclusions. For example, in the UK, VAT is payable on chocolate-covered biscuits, but not on chocolate-covered cakes and the non-VAT status of McVitie’s Jaffa Cakes was challenged in a UK court case to determine whether Jaffa Cake was a cake or a biscuit. The judge ruled that the Jaffa Cake is a cake, McVitie’s won the case and VAT is not paid on Jaffa Cakes in the UK.
Replaced as the official measure of inflation by the consumer prices index (CPI) in December 2003. Both the Retail Price Index and CPI are attempts to estimate inflation in the UK, but they come up with different values because there are slight differences in what goods and services they cover, and how they are calculated. Unlike the CPI, the RPI includes a measure of housing costs, such as mortgage interest payments, council tax, house depreciation and buildings insurance, so changes in the interest rates affect the RPI. If interest rates are cut, it will reduce mortgage interest payments, so the RPI will fall but not the CPI. The RPI is sometimes referred to as the “headline” rate of inflation and the CPI as the “underlying” rate.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
The Consumer Price Index is the official measure of inflation adopted by the government to set its target. When commentators refer to changes in inflation, they’re actually referring to the CPI. In the June 2010 Budget, Chancellor announced the government’s intention to also use the CPI for the price indexation of benefits, tax credits and public sector pensions from April 2011. (See also Retail Prices Index).
Lower interest rates encourage people to spend, not save. But when interest rates can go no lower and there is a sharp drop in consumer and business spending, a central bank’s only option to stimulate demand is to pump money into the economy directly. This is quantitative easing. The Bank of England purchases assets (usually government bonds, or gilts) from private sector businesses such as insurance companies, banks and pension funds financed by new money the Bank creates electronically (it doesn’t physically print the banknotes). The sellers use the money to switch into other assets, such as shares or corporate bonds or else use it to lend to consumers and businesses, which pushes up demand and stimulates the economy.