Investment Markets » Banking and Finance
How High Will Interest Rates Go?
The hawks in the Bank of England may swoop again to quash inflation. Is there a danger of overkill?
When Mervyn King abandoned his famous pledge "to make monetary policy boring", wrong-footing almost everybody by announcing a shock quarter-point rise in interest rates to 5.25%, there was suspicions that something nasty was lurking. Now we know what it was.
Inflation measured on the consumer price index, leaped to an 11-year high of 3% in December, bringing the Bank of England governor within a whisker of having to write a humiliating letter to the Chancellor explaining why. In the event, he was able to keep a lid on his fountain pen, but the Bank has not escaped unchastened.
For the first time since it gained independence, audible murmurs of criticism can be heard across the City. Plainly, a blunder must have been committed to explain why inflation has reached this level.
Had King actually written his letter, it might have gone something like this: "Dear Chancellor, I've done my bit. I've put up interest rates three times and shocked 'em while they were still enjoying the January sales. Now the price of oil is falling. As long as it stays that way, we'll be OK..."
Fortunately for the Government, which pressed a similar line, that is the view of many economists. The sudden CPI surge can be explained by last year's energy price hikes and, with the oil price now falling, inflation will be back on its 2% target by autumn.
But King and his colleagues cannot afford to live so hopefully. Their obsession has been to avoid second-round effects of inflation, yet reports suggest pay settlements this month are running at 4%. Another rate rise is odds on. Some believe rates may go as high as 6%.
If that happens, the pips would really begin to squeak. Overkill now would risk a recession in 2007. The Bank should resume its "boring" ways and do nothing at all until the effects of recent hikes have worked their way through. But headline inflation is hardly the only factor in play. At present, interest rates do not look high enough to curb the housing boom and if house prices keep rising, so will inflation.
With the economy forecast to grow at or above trend this year, there is room for further tightening: it won't be popular, but it would be wise. The harder the Bank of England leans against inflationary pressures, the better the ability of the UK economy to pull through the downturn when it comes.
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