Where should Interest rates go?

The Bank of England is currently in a bit of a tricky situation. Do they cut Interest rates to help economic growth, raise them to combat inflation, or simply leave them alone?

Interest rates have remained at around 5% for some time now, and this is in response to inflation being at 4.4%(August 2008) far above the BOE's target of 2%. Some, therefore, argue interest rates should go up even more to get inflation back down to the Banks target. It is important to keep inflation down, because it can result in second round effects such as wages rising, which then causes inflation to go up even more.

However the BOE, also has to consider Economic growth, which has severely slowed, in fact the UK's economy neither grew nor shrank in the second quarter of 2008. In order to stimulate the UK's economy the bank should really cut interest rates to stimulate demand, and also things like the housing market, which has slowed massively due to the credit crunch.

So what should the bank do? Cut interest rates to help the economy, or raise them to combat inflation? Well it is my belief the bank should cut interest rates. This is because yes higher inflation can lead to second round effects such as higher wages, but i do not believe we will see this. This is because as the economy slows, many more people will become fearful of losing their jobs, and will therefore not go demanding 5% pay rises to combat inflation. We have definitely not seen this yet (except oil tanker drivers). Furthermore if the economy goes into a major economic downturn inflation will not even become a problem because consumer spending, and spending in the economy as a whole will massively decrease. Finally interest rates mainly control inflation, which has been caused by demand. The inflation, we are seeing is caused by rising commodity prices, such as oil, gas and food. Therefore, raising interest rates is having little effect on inflation, because these types of goods are things we have to buy no matter what (they are inelastic). The price of these goods are also expected to come down in the near future, thus easing inflationary pressure.

The BOE, therefore in my opinion, should worry less about inflation, and concentrate more on the very fragile economy, like the FED did in the USA.