World Economy

BoE to Raise Interest Rate Over Fears of Deflation

BoE to Raise Interest Rate Over Fears of Deflation BoE to Raise Interest Rate Over Fears of Deflation

Fears that Britain could sink into a damaging “deflationary spiral” have stayed the hands of Bank of England policymakers who had pushed for an early interest rate rise, monetary policy committee member Martin Weale has revealed.

Weale was one of two MPC members who had consistently voted for higher borrowing costs from August last year, as the economy recovered. But after falling oil prices drove inflation down to 0.5% in January, Weale and his fellow anti-inflation “hawk”, Ian McCafferty, backed down and agreed that rates should remain at their record low of 0.5%, Reuters reported.

In an article for the Observer, Weale, an independent member of the MPC, which meets each month to set interest rates for borrowers across the UK, explains publicly for the first time what made him change his mind.

Falling oil prices have so far been a boon for consumers, Weale says. But if everyone starts to assume that prices will continue declining, deflation can take hold.

  Deflationary Spiral

“If very low expectations of inflation were to become entrenched, there would be a risk that the economy would sink into a deflationary spiral. Wages and prices could fall, people might put off spending if they thought things would be cheaper in the future, and they would find that, even though interest rates were very low, their mortgages became a burden which was difficult to manage,” he writes.

He adds: “The further the price of oil fell, and the lower the current inflation rate sank, the bigger this risk became.”

Mark Carney, the Bank’s governor, was forced to write a letter to the chancellor, George Osborne, last week, explaining why the bank had allowed inflation to drop to more than one percentage point below the bank’s 2% target. The MPC now expects average prices to fall in some months this year. But at his quarterly press conference, Carney played down the risks of a deflationary slump – while stressing that the bank still has weapons at its disposal to tackle falling prices, including a fresh cut in interest rates from their record low of 0.5%.

The governor said lower energy and food costs would underpin the fastest growth in real (inflation-adjusted) take-home pay for a decade in 2015, boosting consumers’ spending power.

  Pay Rise

The fall in oil prices arrived at a fortuitous time for the coalition, staving off a rate rise – which could have pushed up voters’ mortgage costs – and boosting take-home pay.

Prime Minister David Cameron urged firms to respond to lower energy costs by raising wages, arguing it was “time Britain had a pay rise”.

“At the moment it’s a good thing for the economy – and obviously the government will be hoping it continues until the election,” said Howard Archer, of consultancy IHS Global Insight.

Danny Blanchflower, a former independent MPC member and now a professor at Dartmouth College in the US, said Weale and McCafferty were always wrong to assume the economy could withstand a rate rise. “If you look back, what’s absolutely clear is that all the votes from the hawks were absolutely mistaken,” he said.

However, Weale stresses that a few months of weak inflation have not completely allayed his fears that wages and prices could start to pick up again, underlining policymakers’ uncertainty about the outlook for the economy in 2015.

City investors are betting that rates will remain at rock bottom for at least another year; but Weale predicted that they would eventually have to rise, “somewhat earlier than market participants currently expect”.

February’s inflation figure will be published on Tuesday and is expected to be even weaker than January’s.