UK Inflation Must Fall Before Interest Rates Can Go Up

So another week but the focus is the same. Where's inflation going and what's the impact on the consumer and growth? Last week the Bank of England said inflation could hit 5 percent and tomorrow April CPI could rebound to an annual rate of 4.4 percent.

Governor of the Bank of England Mervyn King
Getty Images
Governor of the Bank of England Mervyn King

For the fourth quarter in a row the bank also guided lower on growth and the Item Club talks about consumer spending set to remain below pre-recession peaks until at least 2013.

High inflation driven by the Value Added Tax hike and increases in food, energy and clothing is one cause, the other — and this is key for monetary policy — is the weak earnings growth.

This will be highlighted again with Wednesday's labor market figures. As a result the Item Club says "the squeeze on household budgets is only going to intensify this year" as we "experience a second consecutive year of declining disposable incomes."

In this environment it's very hard to see how the bank can raise rates. Growth is the key — and the key driver of growth in the last 30 years, the consumer, is completely under the cosh.

In fact I'm now in the rather bizarre position of saying until current inflationary pressures ease the Bank can't think about raising rates. Bank of England Governor Mervyn King has said he doesn't do "gestures", which means when rates do go up from this ultra low level he'd like it to be the start of a normalizing cycle, one which the economy could cope with.

Another Two Years of Low Rates?

Right now the only way his inflation target could be achieved would appear to by driving the country back into recession. Rates can only go up when we believe the consumer can deal with them and that means when some of the pressures have started to ease.

As it's unlikely to come from wage settlements, which the Item Clubs says are only going to increase very slowly given the significant slack in the economy, the relief will have to come from lower inflationary pressures.

In that light, the fall in commodity prices of the last two weeks has been most welcome, but the evidence of so much speculation in these markets and the increased volatility means it's difficult to work out where prices will be at year's end.

Unfortunately even without the speculation, a sustained fall in commodity prices would probably still require a reduction in emerging market growth, which feeds back negatively into the increased reliance on exports.

On top of this I haven't even mentioned euro zone peripheral debt. The greatest fear is that we can't manage an orderly restructuringand risk a second great bank crisis at a time when we're far less able to deal with it.

When UK rates hit their current level, Capital Economics Roger Bootle suggested, they might stay there for five years. We're nearly half way through and while I can't say I agree with him, I am beginning to envisage a scenario where he could be right.