The spectre of base rate rises

The coalition Treasury has a big macroeconomic strategy. Borrowing slashed so that economy-wide interest rates can stay lower for longer. It is how they have made the argument to middle England for the spending and tax pain announced yesterday.

Unfortunate, then, that within hours of the ‘austerity budget’, the Bank of England’s monetary policy committee reveals it’s first single vote in favour of an interest rate rise for nearly two years. To be clear, Andrew Sentance was outvoted by the other members of the MPC, however the concerns about the persistence of high inflation are clearly shared by others on the committee.

This was not a verdict on yesterday, as the vote occurred a fortnight ago. Nonetheless, the budget documents already show much higher outlook for inflation next year, mainly as a result of the VAT rise. The projection for the retail price index is nearly one full percentage point higher.

The chances are that the austerity plan will lower the long term outlook for inflation, and in the short term the Bank will continue to ‘look through’ the spike in inflation caused by the VAT rise. But today’s shock contemplation of rate rises show the interest rate worm is turning, that some key rate setters feel that the committee cannot to continue to ignore above target inflation.

The coalition treasury has sailed close to the wind in announcing that their plans would mean ‘lower interest rates’, and today’s vote is a clear reminder that the Bank of England’s independent committee will ultimately decide. My sense is that the Bank insiders are in no hurry, and will be heartened by the budget austerity plan, but the decision is not for them alone.

And that means the triple whammy of savage spending cuts, sharp tax rises, and benefit restrictions, could be accompanied with the nightmare of higher interest rates.