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Inflation To Rise – We expect UK, ECB and US Policy to Diverge

Inflation To Rise – We expect UK, ECB and US Policy to Diverge

Purely for geopolitical reasons, namely frustration at the failure of the governments of individual member states to respond to repeated calls for “structural reforms”, your authors had taken the view in recent months that the ECB might increase interest rates this year.

Our views are changing. The key to variances in interest rate policies is likely to be the 
relative tightness of labour markets in Europe, the UK and the US. In each of these three currency zones, when inflation has appeared (since the Great Financial Crisis) it has confined itself to the product market. Put differently there have been no spill over effects in the labour market. Because inflation has been small and limited to the product market, the impact on central bank policy has been minimal.

UK Interest Rates Should Rise Sharply Owing to Its Tight Labour Market 
John Butler recently wrote an article in The Guardian warning that, owing to several factors, consumer price inflation (CPI) in the UK, mid-January at 1.2%, could soar to 4% this year. Highlighting the base effects of the 20% fall in sterling’s value against the dollar and euro since the Brexit referendum, together with the near doubling of oil prices and increases in the prices of other commodities, he drew attention to the tightness of the UK labour market.

In fact, UK labour costs are rising against a backdrop of stagnant productivity. Noting that workers’ unions are already sabre rattling in limited competition industries such as government, healthcare and transport, inflation has crossed from the product market into the labour market, and it will probably be impossible to contain because, wage increases in a tight labour market have such a strong bearing on product costs, and so commences a spiral. Indeed, the only way to prevent the price level rising to more than double the 2% target is for interest rates to be raised, perhaps sharply.

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