The dilemma the Bank of England confronts

On May 10, the Committee of Monetary Policy by the Bank of England had a meeting in order to decide the interest rates for UK economy. The committee decided the interest rates to remain at 0.25% amidst a growing concern about the rising inflation and the effects it could have on household income and economic activity in general.

According to the Monetary Policy Committee of the Bank of England we could argue that the overall performance of the economy is satisfactory since it present a continuous growth for the last four and a half years, output increase of 2% in 2016, unemployment is at 4.6% representing a historical low since 1976 and exports have increased compare with the last year. Although the statistics by the Inflation Report for May 2017 and the Monetary Summary of 2017 by the Bank of England (BoE) show to us a strong performance, there are also reasons for concerns. Mr. Haldane, the chief economist of the Bank of England, mentioned in his speech at National Science and Media museum in Bradford wages, work and monetary policy and referred to the challenges the economy has to face in respond to a growing consumer price inflation which squeeze the households income. The Governor of BoE Mr. Carney after the meeting of the MPC on May 10 and more recently in his speech at Manion House on May 20 has confirmed the growing skepticism in the committees board about the increasing inflation pressure on households income and the effect on aggregate demand. The reason for the increasing concern is that CPI is at 2.9% which is above the target of 2% the Central Bank is committed to achieve.

Except for the increasing percentage of CPI, other facts that concern the Bank of England is the slow rate of growth for the first quarter of 2017 which is 0.2% lower, the stagnation on wages and household income, although unemployment is low, and the uncertainty over the Brexit negotiations and its impact on UK trade. Mr. El-Erian in his article on Bloomberg commented that the UK economy is now under pressure because stagflation have a negative effect on aggregate demand since households would reduce their consumption in order to respond to the growing cost of products. Also the uncertainty over the Brexit negotiations will undermine Business investments, but more importantly the issue about how UK will interact with its major trading partners after Brexit. The exports due to the depreciation of the currency seem to have better results, but it’s questionable if they would be large enough to act as the locomotive of growth for the economy.

The Dilemma the Bank of England face is if will increase the interest rate in order to master inflation or if it must continue to have low interest rates.IN the last meeting of the MPC the Governor announced that the interest rate will remain at 0.25%, although the result was a close call with three out of eight members of the committee to favor an immediate increase of interest rate in order to combat inflation. The rate of interest remain the same since August 2016 with the purpose to make credit more accessible and with low cost for households and business alike. But the members of the committee that vote for increase in the interest rate show their concern about the increasing inflation and the negative effects that has in households income. The same concern also has the Governor Mr. Carney and for this reason in his announcement after the committee decision opted that in near future the interest rate must increase according the economic environment at the time, more importantly his argument was that the committee needs to see the influence of the other determinants of aggregate demand before proceeding with an increase on interest rates.

The linked relationship between interest rate and inflation is the cause the dilemma the Bank of England faces.. When interest rate is low households could acquire more credit, this result in consumers to have more money to spend in consumption causing the economy to grow and inflation to rise. The opposite happens when interest rate increase, then the consumer has less money to spend in consumption causing a hold in economic growth and inflation decline. Firms could also be affected by the interest rate, particularly their investments projects. When the interest rates are low, corporations have more access to credit and could increase their investments thus increasing production, jobs and wages. The opposite happens when interest rates increase, then credit becomes more expensive for firms which make them reduce their investment expenditures causing a fall in production, job creation and income. The decision to increase or reduce the interest rate is a dilemma any Central Bank has, and in order to decide it must carefully examine the national and international economic environment and which effect (positive or negative) will have the most profound and long-term impact. For the time the household stagnant income seems to weigh heavily in the monetary policy committee but the growing concern about the inflation eventually will lead the Bank of England to increase the interest rate in the near future. As the Governor of BoE comment in his speech, the behavior of other demand determinants will be important factor for the decision about the interest rates.

The Determinants of aggregate demand are four categories of expenditures that ceteris paribus affect the Demand, those being: consumption expenditures, investments expenditures, government purchases and net exports. In the field of the two components we already discuss the influence of interest rates as for the other two, governments purchases is still unclear how they will move since after the election of June 2017 we need time for the government to form and implement its public policies about taxes and expenditures, on the subject of net exports the increase of exports were a positive sign according to MPC but it was also the result of the depreciation of the currency due to the Brexit Referendum of June 2016 which makes UK products and services more competitive in comparison with other economies such as USA, France and Germany.

We could easily conclude according with the view of the Governor of Bank of England that until we have a more clear economic policy from the government in the issues of taxes and expenditures and the first result from the policy that the new government intend to implement the dilemma of the interest rate will continue to debated in the members of the Monetary Policy Committee without any clear result yet.