Interest rate dilemma for the Bank of England's MPC

The Bank of England's dilemma

Image showing memebers of the Bank of England committee
The Bank of England's interest rate-setters on the Monetary Policy Committee (MPC) had a tough decision to take on 10 March. They had to decide whether to raise rates from the record low of 0.5% where they have stood for the past two years.
Chart illustrating the changes in committee voting patterns over the last 12 months
One member, Andrew Sentance, has been alone in voting for a rate rise for most of the past year. But in the meetings in 2011, others have been joining him, and last month the motion to keep rates unchanged was only carried by six votes to three.
Line chart showing the fluctuation in inflation over the last eleven years
Those voting for an immediate rate rise have been concerned that there is not yet any sign of inflation coming down. Raising rates is supposed to reduce inflation. The MPC's job is to keep inflation measured by the Consumer Prices Index at around 2%.
Chart illustrating the growth of GDP quater on quater for the last 2 years
The majority view in March was that the rate rise should be delayed because the main risk on inflation was that the weak economy could send the rate of inflation well below the 2% target. This fear was stoked by the contraction in the UK economy in the last three months of 2010.
Graphic comparing the relative size of America and Chinas wealth gap
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There was more doubt about the result of the Bank of England's interest rate-setting meeting this week than there has been for a long time.

Some excitement was overdue. For those people who are for some reason not excited by quantitative easing, nothing has been changed by the Monetary Policy Committee (MPC) for two years.

For all of that time, the Bank of England's base rate, on which many loan rates are based, has been unchanged at its record low of 0.5%.

There have been precious few voices during that time suggesting that rates should be changed, largely because the rate was so low it could not be cut any further, and the economy was in such a poor state that nobody would consider a rate rise.

But in June last year, a lone voice on the committee suggested that inflation was getting dangerously high and that a rise in the cost of borrowing would be needed to bring it under control.

Andrew Sentance remained a lone voice until January this year, when a second member of the nine-man committee joined him in voting for an increase. In February there was a third supporter.

Why the dilemma?

The MPC's only job is to keep inflation as measured by the Consumer Prices Index at around 2%, and at the moment it only really has one tool to achieve that, which is changing interest rates.

So why is there such a dilemma?

The problem is that inflation is considerably higher than the 2% target. In January it was double that rate at 4%.

Usually, when inflation is too high, the MPC raises rates to try to push them down again, but there is a problem with that policy.

The majority of the MPC believed in February that inflation would come down of its own accord as a result of the relatively weak economy and that there was a danger that raising rates now would hinder the recovery that is already in doubt following the contraction of the UK economy in the last three months of 2010.

Also, some of the rise in inflation is a result of the rise in VAT from 17.5% to 20% at the start of the year, which the MPC could reasonably conclude was not its problem.

There is no question that interest rates will have to rise at some point, but at the moment the decision seems delicately balanced between fears of inflation and fears of damaging the recovery.

The committee may have decided to keep rates on hold this month, but that just means there will be even more focus on the outcome next month.

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