Evanomics

Inflation predictions

• Evan Davis | Vital Statistics |
• 16 May 07, 04:47 PM

The Bank got it wrong last year. It thought inflation was under more control than it was. It's now having to catch up -- and it seems that for that purpose, interest rates will rise another time.

The Bank's projection for inflation sees inflation coming in on target, on the assumption that rates go up another quarter point or so.

That would be the fifth rise in the latest sequence, and would push base rates to five and ¾%.

As the risks still seem to be "on the upside", we can't rule out the idea that rates may have further to go after that.

For borrowers, it might feel as though the pain is never-ending -- but in recent history, when interest rates have moved up or down, they have done so in cycles that amount to about 1 and ½ percentage points. On that basis, you might expect two further rises if this is an average cycle -- let alone a painful one.

Here is the data of peaks and troughs in recent history -- the average move up or down between the extremes of the cycle is 1.40.

Feb 94      5.25
Dec 95      6.50
June 96     5.75
June 98     7.50
June 99     5.0
Feb 00     6.0
July 03     3.5
August 04     4.75
August 05     4.50

Now this is not particularly helpful in providing exact guidance as to the magnitude of interest rate cycles, as it is hard to decide whether the current interest rate is part of a short cycle that started from the 4.5% trough of August 2005 to 2006. Or whether it is part of a long cycle that started back when rates were 3.5% in 2003. It depends whether you think the 4.50 in 2005 was itself a cycle, or a (probably misguided) digression from an upward swing in rates.

But the point of this data and the argument over the magnitude of cycles is not to predict how far rates will go, but to remind us that rates do move about in a range, and we should not let the recent relatively narrow history of rates limit our horizons as to how broad the range typically is.

People seem shocked by the idea that rates may reach 6%. I think we can say it would be surprising if they went that high, but not shocking. It is quite within the range of possibilities suggested by recent experience.

The real problem though, is that we don't actually know. As the last year has proved, inflation is unpredictable.

Some people think they can (and did) predict it -- but the problem for the rest of us is that we can never be sure their prediction is the right one for us to be following.

The key thing is not to fixate on a particular prediction of rates, but to prepare for realistic scenarios, to which history can be a useful pointer.

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