BoE unlikely to raise rates this week

When The Bank of England's (BoE) Monetary Policy Committee meets later this week, they are certain to maintain the same low benchmark rate of 0.5% that they've had since March 2009, amidst mounting evidence that the nation's recovery is faltering, while inflation seems to be picking up.

Further muddying the waters, Britain's newly-elected coalition government has warned the country's budget deficit is worse than previously reported and will impose a series of long-term draconian spending cuts to curb that runaway debt.

James Cameron, the new Prime Minister, said if the government does not take action now, the annual interest payments alone on the country's debt could surge to a staggering 70-billion pounds sterling a year by 2015 (the annual interest is currently less than half that figure). Britain's total budget deficit amounts to about 156-billion pounds, or nearly 11% of the GDP (an alarmingly high level for such an advanced, industrial nation).

In addition, the growing sovereign debt crisis on the European continent may also cast an unpleasant shadow over Britain.

In effect, if the BoE doesn't hike rates now, inflation could run out of control, choking off any semblance of a sustainable recovery; but, on the other hand, if it does raise rates now, the economy could face the risk of slipping into a double-dip recession.

"The BoE is in a very vexing position to say the least," said Sean M. Snaith, an economist at the University of Central Florida,
"Referring to Greek mythology, the BoE finds itself trying to navigate between Scylla and Charybdis. They are trying to avoid the downward pull of the whirlpool of the EU/Greek crisis, its own lackluster recovery and potential for a double-dip recession while riding perilously close to the monster of a sustained inflationary episode."

Pulling back on fiscal policy would further dampen the recovery and may necessitate that monetary policy remain stimulative for some time to come.

"I do not think they will raise rates this year, but I think a rapid rate hike in the first half of 2011 will be necessary to choke off inflation," he added.

However, James Cox, managing partner of Harris Financial Group in Colonial Heights, Va., takes a somewhat different view of Britain's inflation.

He points out that even if inflationary pressures accelerated in Britain, the BoE would have even less of an incentive to hike rates because of the nation's burdensome debt.

"When your country is as heavily-indebted as the UK appears to be, inflation may be your only way out because it would lower the real value of that debt," he said. "Contrarily, the risk of deflation would be devastating since under that scenario, the country's debt would become monstrous and could potentially wreck their economy. Moreover, it's easier for a central bank to break the back of inflation, rather than deflation."

Britain's inflation rate spiked to 3.7% in April (well above the BoE's 2% target), but the Bank's governor Mervyn King believes that was likely an anomaly and that inflation will ease.

Cox expects the benchmark rate in Britain to stay exceptionally low (at or near-zero) throughout this year and for a "good portion" of 2011.

One especially important voice in the wilderness believes the BoE needs to start moving on hiking rates before it's too late.

The Organisation for Economic Cooperation and Development (OECD) recently opined the Bank should raise the 0.5% rate by the second half of the year, while simultaneously unwinding the £200bn of quantitative easing that was inserted into the economy.

Does Britain's current monetary policy environment have any similarity with the Federal Reserve in the U.S.?

While central banks in the UK and US have both maintained an extremely accomodative stance for the past year and a half (the duration of the global economic crisis), they are doing so for slightly different reasons – so the two countries are really not comparable.

"The Bank of England has a rather simple mandate: maintain price stability," Cox noted. "Whereas the Fed's mandate is to maintain both price stability and maximum employment. This means the BoE has more flexibility in its policy-setting, whereas the Fed sometimes has to answer to political considerations."

Either way, historically low emergency rates are likely to remain in place on both sides of the North Atlantic for the remainder of the year.