Official interest rates UK
A senior Bank of England official has raised the prospect of interest rates rising sooner than expected if economists are proved wrong about the power of a strong pound to hold down inflation.
Kristin Forbes, one of the nine rate-setting members of the Bank’s monetary policy committee, questioned whether current economic models were accurately reflecting the relationship, or “pass-through”, between exchange rates and the outlook for inflation. That, in turn, had important implications for monetary policy, she said in a speech.
“This limited understanding of how exchange rate movements affect inflation is – to be candid – quite frustrating for those of us tasked to set monetary policy. This is a crucial relationship – especially for an open economy such as the UK, ” Forbes told the Money Macroeconomics and Finance research group conference in Cardiff.
The stronger pound has cut the price of UK imports and is seen as a key factor in keeping inflation hovering around zero in recent months. With inflation well below the Bank’s government-set target of 2%, financial markets are not expecting interest rates to rise until next year.
However, Forbes suggested economists wanting to gauge the implications of currency moves for inflation needed to place more weight on the underlying causes of exchange rate movements.
Based on her analysis of recent factors behind the relatively strong pound, its downward effect on inflation seemed more muted than in the past, said Forbes, a US economics professor.
“Perhaps most important for monetary policy today, this approach also suggests that sterling’s recent appreciation could create less drag on import prices and inflation than we might have expected if the levels of pass-through seen after the crisis persisted, ” she said. “If this plays out, monetary policy would need to be tightened sooner than based on the older models.”
Forbes suggested central banks need to look again at how they factor in currency movements and that in the UK’s case, the pound’s strength should not necessarily delay a rate rise.
She laid out what she considered to be three misunderstandings around exchange rates and inflation. Forbes argued that “contrary to common belief, exchange rate movements don’t seem to consistently have larger effects on prices in sectors with a higher share of imported content”.
Second, exchange rates do not seem to consistently have larger effects on prices in the most tradable and internationally competitive sectors. Third, the effects of exchange rates on inflation – and even just on import prices – “do not seem to be consistent across time”.