Britain falls into negative real interest rates

UK Inflation Exceeds Interest Rates for First Time Since 1981

By Edmund Conway
The Telegraph, London
Tuesday, August 12, 2008

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/08/13/cncpi1...

Interest rates have fallen below the cost of living for the first time in 27 years.

In a landmark moment for the Bank of England, Britain now has negative real interest rates, news which will heighten calls for the Monetary Policy Committee to raise borrowing costs.

Retail price index inflation (RPI) -- the most comprehensive measure of living costs -- rose to 5 percent last month, according to the Office for National Statistics.

The rate was actually slightly above 5 percent -- the current level of the Bank's base rate -- although it was rounded down to one decimal place.

RPIX, the measure which excludes mortgage payments and was until recently targeted by the Bank, rose beyond even this to 5.3 percent.

Not only are the inflation rates all at their highest level since the early 1990s, before British economic authorities started targeting inflation, this is the first time mainstream inflation measures have risen above the official bank rate since 1981.

In August of that year, RPIX rose to 12.1 percent, while official policy rates were at 14 percent; the very next month policymakers raised borrowing costs by two full percentage points to 14 percent.

When real interest rates -- namely after inflation has been subtracted -- are in negative territory, it puts the economy in the unusual position where it becomes "more attractive to spend rather than to save," according to Philip Shaw of Investec. "At the current rate, borrowing is more attractive than saving."

Although experts said there were important distinctions between now and then, the landmark moment underlines the strength of the recent inflation surge.

The ONS said consumer prices index inflation (CPI), the measure targeted by the Bank, which does not include the effect of housing costs or council tax, rose from 3.8 percent to 4.4 percent in July. With the measure more than double the Bank's 2 percent target, economists said there was a growing chance that the MPC will raise borrowing costs in the coming months.

However, the Bank, which presents its closely-watched Inflation Report today, had received a preview of the inflation figures at the time of the MPC's meeting last week, at which rates were left on hold.

The Bank has previously predicted that inflation will drop back next year as prices are restrained by the weakening broader economy. However, some expect it to hint of a forthcoming rate increase today.

Michael Saunders, chief European economist at Citigroup, said that while the rise in RPI and RPIX to above the base rate was an "important landmark", it should not be taken as a sign that interest rates are excessively low.

He said: "The idea that the real cost of money is zero is usually founded on the idea that people's incomes are rising at a relatively fast rate. But at the moment wage growth is not high enough by itself."

The Bank has warned that if it sees evidence that wage inflation is rising, it may be inclined to raise rates.

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