British Pound Finally Awakens to Inflation feeding Rising UK Interest Rates

By: Nadeem_Walayat

Inflation as measured by the CPI jumped above 3% to 3.1%, which now virtually guarantees a hike in UK interest rates to 5.5% at Mays Bank of England MPC Meeting. The British Pound surged through the $2.00 barrier, having flirted with it for nearly 2 years now, each attempt at a break having held, but no more !

Both the rise to 5.50% at the May meeting and the Pounds jump above $2.00 have been long forecast and expected.

The Story of 2007 has been and will continue to be of higher interest rates across the world. Not just for the UK but for most major economies. The resulting effect is already being seen in the currency markets with a selling of the US dollar especially against the Euro and Sterling.

The Target for UK interest rates, set way back on 7th November 2006, is for UK interest rates to hit 5.75% this year, (UK Interest Rates could rise to 5.75% in 2007) . The time line for this is a rise to 5.5% in May, with the following rise to 5.75% scheduled for August / Sept 07.

The underlining reason for this remains the surging money supply, relative strength of the UK housing market and economy which continues to force inflation ever higher. This was expanded upon in the article of 26th Dec 06 UK Interest Rate forecast for 2007 - Bank of England to do battle with inflation ,

The rise to 5.50% for May 07, was reinforced in March 07, with the failure of the subprime mortgage fallout to impact on the UK housing market, and expectations of the UK housing market gathering strength as it moved into the traditionally strong summer demand period. UK strong house price growth signals further rises in interest rates

UK interest rates in real terms remain at historic lows. We have the CPI index (the fake inflation indices) at 3.1%, which despite being manipulated has nudged above its upper band of 3%, which basically automatically calls for a rise in UK interest rates. The closest thing the UK has to an accurate measure of inflation is the RPI index , this index is the one people actually pay attention to with regards all aspects of the UK economy, from pay deals to indexation of government bonds to increases in social benefit payments. The CPI is by and large ignored by the 'real' economy.

Now the RPI, which also once upon a time had an inflation upper limit of 3%, was abandoned when the Government switched to the CPI, the RPI is now accelerating to 4.8%! With the current base rate at 5.25% the resulting real rate of return is just 0.45% ! The following chart first published in 2006 indicates the real rate of return spanning the last 20 years (Oct 06 - UK Interest Rates Forecast to rise much higher due to rising Inflation and high Money Supply Growth).

As you can see despite interest rate hikes to date, real interest rates remain at historic lows, which means that the rises thus far have had little impact on inflation. We are still nowhere near the end of the current rate hike cycle. Yes the 5.75% target is likely to be hit this year. With the next rate rise due in little more than 2 weeks time. But as things stand, in real-terms 5.75% may just mark a stop gap on route to further UK interest rates during 2008.

This expectation is reinforced by rate rises across the world, in the Euro zone interest rates are due to rise to 4.5%. For historic reasons, the European Central Bank of all of the worlds central banks is probably the most aggressive when it comes to curbing inflation.

In the US, despite the noise of a weakening economy, the Fed is not done raising rates, how high could rates in the US go ?, despite concerns of the economy has fast become a basket case. Being tugged in both inflationary and deflationary directions following the housing bubble bursting. The mood is increasingly reminiscence of a stagflation environment leading to a US recession sometime during 2008.

The Japanese economy is weak, with major deflationary forces at work so therefore the scope of interest rate rises there is much less, which means that the Yen is expected to reman weak. Japan continues to flood the world with cheap money, having the effect of exporting inflation abroad, with this excess liquidity chasing assets such as gold and stocks ever higher. Which is probably why the central bankers such as the Bank of England are sat scratching their heads wondering why the rate rises to date are having little or no effect on inflation.

As we approach nearer to 5.75% UK interest rates, it becomes relatively easy to consider even higher interest rates of 6.5%. Way back in November 2005 two targets were stated for UK interest rates, first 5.75%, to be later followed by 6.5%. Over the coming months I will seek to revise the long-term forecast to determine whether 5.75% will represent the peak or merely a stop gap on route to 6.5%. Though, without prejuding too much, I would caution the inflationary bulls to not run too far ahead of themselves.....

A quick look at the British Pound, GBP/USD. Before the sterling bulls get carried away with themselves, take note of a word of caution, namely that breaks above £/$ 2.00 are usually shortlived, and tend to mark peaks for sterling ! But for now, maybe a few more days or weeks, enjoy the ride :)

And finally, make sure to check the Summary Forecasts page this coming weekend for a long overdue major updates across all financial markets.

By Nadeem Walayat
(c) MarketOracle.co.uk 2007

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