Will interest rates rise this week?
This Thursday the Monetary Policy Committee will issue its latest interest rate decision.
As inflationary pressures mount it is under increasing pressure to raise rates. However, a small but vocal minority claim this would have a detrimental effect on our fragile economy. Here we look at the arguments for and against a rate rise.
Monetary Policy Committee member Dr Andrew Sentance has been arguing the need for a rate rise since last June but at the last MPC meeting in January he was not alone in his views. Fellow member Martin Weale also voted for a 0.25% rise. But why?
The main issue is inflation.
When interest rates rise it incentivises people to save and discourages them from borrowing because they get a better rate of return of their savings and their borrowing costs more.
This has the effect of taking money out of the economy, as people spend less. This reduces demand in the economy which should push down the cost of goods.
Consumer price inflation rose to an annual rate of 3.7% in December, up from 3.3% in November. The figure was higher than the 3.4% expected and way above the target of 2%.
Sentance has said higher interest rates would help to protect savers from the effects of higher inflation by raising the return on their savings deposits.
His views have been backed by Charles Bean, deputy governor of the Bank of England. Bean says the increase in the cost of fuel and food could cause inflation to rise further and argues this would need to be curbed using monetary policy.
"It is one of the risks that continuing strong growth in emerging markets may mean a tendency for commodity prices to continue to rise relative to the general prices of goods and services," he says.
Ros Altman, director general at Saga, has also commented on the detrinmental effect this has on pensions.
"Even though the state pension is linked to the retail price index at the moment, many pensioners are seeing the real value of their savings or their annuities being eroded by inflation," she says.
"It is time to step up the pressure on the Bank of England to call for rates to rise from the current excessively low 'emergency' levels. The dangers of not raising rates are actually greater than the dangers or increasing them."
But not everyone is hoping for a rate rise. David Kern, chief economist at the British Chambers of Commerce, argues the economy is still too fragile to handle a rate rise.
Read: Interest rates must not rise in 2011, warns think tank
He says while figures from the Purchasing Managers' Index showed businesses rebounded well following the disruption caused by the snow in December, the MPC should not be too hasty.
"We are concerned that recent positive figures could heighten pressure on the MPC to raise interest rates too early," he says.
"The UK recovery is still fragile and the more forceful implementation of the government’s austerity plan will inevitably have negative effects on business cashflows and consumer disposable incomes.
"While we support the Government’s continued deficit cutting programme, we believe it is important to ensure that the recovery continues and there are no setbacks."
His opinion is echoed by the Ernst and Young ITEM Club, the only non-governmental economic forecasting group to use the HM Treasury model of the UK economy.
In its winter four-year forecast, the ITEM Club warns that an increase in Bank base rate could endanger the economic recovery in what is going to be a tough 2011.
ITEM says the current high level of the CPI index is largely due to the VAT increases and commodity price rises, and it expects the CPI to fall back to the 2% target when these temporary pressures fall out of the 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.
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.
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).
Generic, loosely-defined term for markets in a newly industrialised or Third World country that is in the process of moving from a closed economy to an open market economy while building accountability within the system. The World Bank recognises 28 countries as emerging markets, including Argentina, Brazil, China, Czech Republic, Egypt, India, Israel, Morocco, Russia and Venezuela. Because these countries carry additional political, economic and currency risks, investors in emerging markets should accept volatile returns. There is potential to make large profit at the risk of large losses.
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).
Also referred to as the bank rate or the minimum lending rate, the Bank of England base rate is the lowest rate the Bank uses to discount bills of exchange. This affects consumers as it is used by mainstream lenders and banks as the basis for calculating interest rates on mortgages, loans and savings.