UK inflation rises to above 3% in March - What next, another interest rate rise?

Last week’s inflation data surprised everyone with the headline inflation rate rising to above the 3% level in March for the first time since 1992. As the current inflation rate is more than 1% above the target of 2%, Bank of England Governor King was obliged to write an open letter to the Chancellor of the Exchequer Brown to explain why inflation has risen above target and what the Bank will do about it.

In his open letter, King attributed the strong increase in inflation over the past year mainly to three factors:

1. An unexpected sharp increase in domestic energy prices during the second half of the year, more than offsetting a fall in petrol prices
2. A rise in food prices caused by a weather-induced global reduction in supply
3. The rebuilding of profit margins by companies, which had previously been squeezed by the doubling in oil prices.

In March, higher petrol and furniture prices and an unfavourable base effect related to milk prices pushed the inflation rate unexpectedly to above 3% from 2.8% in February.

Rather favourable medium term inflation outlook two main risks should however be identified. First, a continuation of the rebuilding of profit margins by companies and secondly a rise in earnings growth as employees seek a compensation for higher inflation.

Regarding the first, in recent months output prices and business surveys have indeed indicated some increased pricing power of companies. The main question whether this will continue will mainly depend on the economic outlook going forward. In this context, you expect that a slowdown in domestic consumer spending as well as tough international competition due to the rise in sterling will prevent companies from raising prices much further.

A 3-way split within the MPC
In this context, it’s also worth noting that there is currently no strong drive within MPC to hike rates further. The latest Minutes of the April meeting showed that the MPC is currently split into three major groups.

The first group, consisting of Blanchflower and most probably Lomax, did not see a compelling case for a rate hike in April, as there were both upside and downside risks to inflation and the near-term prospect for inflation was a fall towards the target in the next few months.

The second group, consisting of governor King, Gieve, Bean, Barker and Tucker, concluded that no rate hike was warranted in April, even while the balance of risks to inflation remained on the upside in the medium term.

The third group, consisting of Besley and Sentance, also thought that the balance of risks was to the upside and agreed that these were sufficiently strong to warrant an immediate rise by 25 basis points.