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Interest rates
The bank decides
Jul 5th 2007
From The Economist print edition
Monetary policy continues to tighten
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IN THE past year the Bank of England has surprised the City twice by raising interest rates. On two other occasions
rate rises were seen as done deals before the bank's monetary-policy committee met. So it was on July 5th: the
increase in the base rate to 5.75%—up from 4.5% a year ago—was anything but unanticipated.
The decision had been widely predicted after the minutes of the nine-strong committee's last meeting were
published on June 20th. These showed that four members, including Mervyn King, the bank's governor, had backed
a quarter-point rise in early June. The markets concluded that this made an early increase virtually certain, and the
pound rose above $2 again, reaching a 26-year high.
But what matters now is the future direction of monetary policy. Has the bank done enough to keep inflation at
bay? Or will it have to yank the base rate up yet again, to 6.0%, as the City expects?
There are two main reasons why the bank might now stay its hand. The first is that the worst of the recent
inflation shock seems to be over. The annual rate of consumer-price inflation came down from its peak of 3.1% in
March to 2.5% in May, and it is likely to fall to the government's target of 2.0% by the end of the year.
The second is that there is a risk of overdoing the monetary medicine. Household finances are fragile: people have
borrowed heavily in the past few years and the savings ratio has declined to its lowest level since 1960. If rates go
too high, consumers might retrench abruptly, which would cause a sharp economic slowdown.
But there are also weighty arguments for the bank to tighten again. The economy grew at 3.0% in the year to the
first quarter of 2007, which is above the trend rate of growth; excluding oil and gas, output rose by 3.2%.
Investment is booming—capital spending jumped by 8.9% over the same period—and consumers have not yet
thrown in the towel.
Business surveys suggest that the economy is operating at close to
capacity, and that companies are primed to push up prices. Rapid growth
in money and credit may also presage inflationary trouble. Broad money
(M4) rose by almost 14% in the year to May, and underlying lending
increased by nearly 15%.
Much depends upon whether pay pressures are building up in the labour
market. On the one hand, the average-earnings index grew by 4.0% in
the three months to April compared with the same period in 2006 (see
chart). This rate is comfortably below the level of 4.5-4.75% that is
consistent in the long term with the 2% inflation target. On the other
hand, an “experimental” official series for average weekly earnings, based
on the same underlying data, paints a less reassuring picture—mainly, it
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seems, because it shows a bigger effect from higher bonuses.
The bank will probably now pause over the summer to gauge the effect of
its monetary tightening. It takes a year for rate rises to exert their
maximum effect in slowing GDP growth, feeding through a year later to
their full impact in dampening inflation. But borrowers beware: a further
rise in the base rate, taking it to 6.0%, still seems highly likely.
Copyright © 2007 The Economist Newspaper and The Economist Group. All rights reserved.
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