Are interest rate rises on the horizon?

18 June 2008

An interest rate rise was narrowly avoided last month, the minutes from June’s base rate vote reveal.

The Monetary Policy Committee (MPC) – which meets each month to vote on whether interest rates should increase, decrease or stay the same – decided to keep the base rate at 5% in June. However, the minutes from the meeting reveal that several members of the nine-strong committee felt that the risk of rising inflation justified a pre-emptive increase in interest rates.

The members – most likely to be Professor Tim Besley and Dr Andrew Sentence – reasoned that delaying rises would only increase the eventual cost of bringing inflation back down to its 2% target.

However, they were argued down by other members. The minutes show that the majority of the MPC felt that an unexpected increase in rates might be counter-productive and potentially alarmist.

In the end, eight members of the MPC voted for interest rates to remain at 5% for June, while one member – David Blanchflower – voted for a cut.

Outlook for interest rates?

The government and the Bank of England have both noted that the economy needs to slow in order for inflation to return to its 2% target.

Following the central bank’s governor Mervyn King's warning inflation could hit 4% before the year is through, the concern is that interest rates will go up as early as next month.

But Paul Mumford, senior fund manager at Cavendish Asset Management, says an increase in rates would be premature.
“Actively seeking to curb inflation by pushing up rates will trigger a short-term rebellion from consumers," he adds. "Most of the inflationary pressure we are witnessing results from singularly high oil and food prices, where the consumer is relatively powerless to cut back. The economy will fight such intrusive, inflationary-busting attempts – wage inflation being the obvious. 

Figures showing record level of retail spending in May may be read as indicating that higher interest rates might be needed to slow the economy. Sales rose by 3.5% during May, the strongest monthly growth since January 1986.

Michael Hume, chief economist at Lehman Brothers, says “hawkish” members of the MPC will probably vote for a hike at the July meeting, while others will want to see rates held and at least one will want a cut.

But he adds: “While a rate hike in coming months is possible, we continue to see the majority of the MPC favouring rates on hold… Importantly, the governor’s open letter yesterday gives us some confidence that the majority is unlikely to support an immediate rate increase.”

Hume also notes that one of the arguments against a rate rise – namely, that it would be counterproductive in that it could exaggerate the MPC concerns about the risk of inflation – will be seen as less important during July’s meeting as the latest Consumer Price Index means expectations for inflation have now shifted.

Despite the need for the economy to slow in order to calm inflation
, Hume says he expects growth concerns to become increasing important to the MPC, meaning a rate cut could still be on the cards in 2008, most likely in November.

Simon Denham, managing director of Capital Spreads, agrees that interest rate rises are not a given. He points out that, in his open letter, Mervyn King noted that the Bank of England is committed to focusing on the rising prices of goods and services rather than commodity prices: “Many have interpreted [this] as an indication that rates will not rise on the back of record oil and petrol prices,” he says.

Denham adds: “The majority of the good and the great (including one supposes ‘our Gordon’ and ‘Captain Darling’) seem to be pushing for the Bank of England to provide some leadership on the struggling UK growth front. Certainly the way sterling reacted after yesterday's inflation data would suggest that the FX markets believe rate rises are unlikely.”

The Council of Mortgage lenders (CML) says the MPC is unlikely to lower interest rates soon.

In its recent market commentary, the CML states: "The Bank of England will not want the current rise in inflation to become embedded. Sentiment has turned quite sharply from a month ago and the markets no longer expect any further rate reductions this year.

"Looking further ahead, the next move is now expected to be a rate increase. As a consequence, swap rates, which reflect the cost of raising funds over specific time periods, have risen and there has been an increase in the price of fixed rate mortgages."

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