No respite for savers as interest rates stick at 0.5%
The headline cost of borrowing was frozen at its record low of 0.5% for the 17th consecutive month while the £200 billion quantitative easing programme was left untouched after drawing to a close in February.
Last month, Andrew Sentence became the first MPC member to break rank and vote for a 25 basis point increase in rates.
Howard Archer, chief UK and European economist at IHS Global Insight, said: "Sentance has consistently been one of the more hawkish members of the MPC and we just cannot see at least four more MPC members joining him in voting for higher interest rates in the near term at least (or three and Bank of England governor Mervyn King casting a deciding vote as Martin Weale does not join the MPC until the August meeting so there are currently only eight members rather than the usual nine)."
He adds that three other MPC members - Paul Fisher, Adam Posen and David Miles - have indicated in recent speeches and articles that they are not ready to vote for an interest rate hike - at least not in the near term.
Edward Menashy, chief economist of Charles Stanley, says: "There are signs that the MPC is fragmenting into three camps. The Governor and Dr Sentance appear to be at different ends of the spectrum regarding the prospect of the CPI returning to target, whilst in the middle there are a variety of views as to whether the CPI will decline naturally."
Economists are concerned that rising interest rates prematurely could strangle the fledgling recovery - despite inflation remaining stubbornly high. This stood at 3.4% in May - down from a 17-month high of 3.7% in April but still well above the Bank of England's medium term target of 2%.
However, there are signs this is starting to head down due to significant extra capacity and the waning of temporary factors including higher energy prices, sterling's past depreciation and VAT changes.
City commentators say the Bank's Quarterly Inflation Report, which is released on 11 August, will be greatly significant in revealing how the MPC assesses the various risks to both activity and inflation.
Recent surveys have also suggested that growth in the dominant service sector is starting to tail off while the manufacturing sector could run out of steam in the second half of the year.
Economists are largely expecting rates to stay on hold for the remainder of the year.
Philip Shaw, economist at Investec, says: "The MPC will be very cautious over tightening until it is reasonably sure that the downside risks facing growth are largely neutralised. We continue to pencil in a modest rise in the first quarter next year and are targeting the Bank rate at 2% by end-2011."
Archer adds: "We had expected interest rates to start rising in February 2011, but this looks questionable with the economy already set to be hit by VAT rising from 17.5% to 20% next January. So the first rate hike may well be delayed until the second quarter.
"And when interest rates do start to rise, the increases are likely to be very gradual and limited due to the need to keep monetary policy loose to counter the major fiscal squeeze. Specifically, we see interest rates only rising to 1.75% by the end of 2011.
Invented by a Frenchman in 1954 and ironically introduced in the UK on 1 April 1973, VAT is an indirect tax levied on the value added in the production of goods and services, from primary production to final consumption and is paid by the buyer. Its levying is complex, with a number of exemptions and exclusions. For example, in the UK, VAT is payable on chocolate-covered biscuits, but not on chocolate-covered cakes and the non-VAT status of McVitie’s Jaffa Cakes was challenged in a UK court case to determine whether Jaffa Cake was a cake or a biscuit. The judge ruled that the Jaffa Cake is a cake, McVitie’s won the case and VAT is not paid on Jaffa Cakes in the UK.
Lower interest rates encourage people to spend, not save. But when interest rates can go no lower and there is a sharp drop in consumer and business spending, a central bank’s only option to stimulate demand is to pump money into the economy directly. This is quantitative easing. The Bank of England purchases assets (usually government bonds, or gilts) from private sector businesses such as insurance companies, banks and pension funds financed by new money the Bank creates electronically (it doesn’t physically print the banknotes). The sellers use the money to switch into other assets, such as shares or corporate bonds or else use it to lend to consumers and businesses, which pushes up demand and stimulates the economy.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
The Consumer Price Index is the official measure of inflation adopted by the government to set its target. When commentators refer to changes in inflation, they’re actually referring to the CPI. In the June 2010 Budget, Chancellor announced the government’s intention to also use the CPI for the price indexation of benefits, tax credits and public sector pensions from April 2011. (See also Retail Prices Index).
Monetary Policy Committee
A committee designated by the Bank of England to regulate interest rates for the UK. The MPC attempts to keep the economy stable, and maintain the inflation target set by the government and aims to set rates with a view to keeping inflation at a certain level, and avoiding deflation. The MPC meets on the first Thursday of each month and discusses a variety of economics issues and constitutes nine members: the governor, the two deputy governors, the Bank’s chief economist, the executive director for markets and four external members appointed directly by the Chancellor.