Rates left on hold as IMF sounds spending warning

With government spending, consumer debt and house prices still rising, the MPC may soon find itself tightening policy
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The Bank of England will have to hike interest rates if the Government embarks on an "excessive" spending spree, the International Monetary Fund warned yesterday.

The warning came as the Bank brushed aside a fresh surge in house prices to keep rates on hold at a 38-year low of 4.0 per cent.

It echoed mounting speculation in the City that it is only a matter of time before the Bank has to start tightening monetary policy again after its year-long programme of rate cuts.

However, this rate fever does not seem to be contagious, at least as far as the Monetary Policy Committee is concerned. Recent comments from its senior members indicated that a rate cut was still on the table. So who is right?

As so often with economics, the answer is that both of these diametrically opposite views have an equal amount of credibility. In other words, there is a similar volume of argument in favour of rates going up sometime in the near future as there is for cutting them.

But let us begin with the IMF's warning, which was contained in its annual assessment of the UK economy. Overall the Fund's report was another high commendation for the UK.

It praised the Government for the "impressive performance" of the economy, which it credited on "sound macroeconomic policies". The Bank was lauded for its "skilful management". But it flagged up the Chancellor's spending and borrowing plans as a potential danger.

"It will be important not to raise the structural deficit beyond the path envisaged in the November pre-budget report," the IMF said.

"The recent revenue shortfall experienced may not prove as temporary as expected, and an excessive push on demand could require sharper increases in interest rates in the future."

The latest public finances figures show spending by Whitehall departments surged almost 15 per cent in January, bringing the total increase so far this financial year to almost 10 per cent.

"Given the rapid increase in outlays over the coming years that existing plans already encompass ... any additional spending should be undertaken only if it is based on a clear-cut economic justification," the IMF report said.

The pace of public spending is top of some City economists' worries about the sustainability of the current pattern of growth in the UK. Higher state spending will in turn increase demand for goods, services and for workers. This will amplify the current strong levels of consumer spending and come at a time when unemployment is actually falling.

For economists such as Danny Gabay, at JP Morgan, this adds up to rates rising to 5 per cent by the end of the year. "We are emerging from 2001 with retail sales at their strongest since the late 1980s, with GDP growth just a fraction below trend, unemployment at a 26-year low and house price inflation at its highest since the late 1980s," he said. "One of those things does not fit and a lot of it is at odds with what the Bank is saying."

For its part, the Bank is certainly playing down fears of an imminent rate hike of the order of a full percentage point currently envisaged by the markets.

While it is increasingly confident that the UK economy is past the worst, it does not seem in any hurry to start fighting any inflationary threats.

"We welcome the strength of house prices and we welcome the strength of consumer spending," the Governor, Sir Edward George, told a House of Lords committee. "We are not uncomfortable with what is going on."

The following day, appearing before a Commons committee, he went further saying he was relaxed about the boom in the consumer economy. "It has to be a concern but I don't lie awake at night thinking about it," he said.

Mortgage lending is currently running at record levels as homebuyers flock to take advantage of mortgage rates not seen since the 1950s. This has naturally fed through to the largest rise in house prices – 16.7 per cent according to the Halifax yesterday – since the boom days of 1989. But the Bank insists this is the deliberate result of its policy of stimulating consumer demand to offset the decline in manufacturing. The Governor's new mantra is that "unbalanced growth is better than no growth at all".

That growth is certainly not to be found in the business economy. Manufacturing contracted 2.3 per cent in 2001, the largest annual fall since 1991 when the UK was in the grips of recession.

The rates of return earned by manufacturers and service providers have fallen to their lowest level since 1992 and 1993 respectively.

Meanwhile, prices of many goods on the high street are still falling while the prices of goods leaving the factory gate rose just 0.1 per cent in January.

Against that background the Bank has forecast inflation staying below its 2.5 per cent for the next two years. For some MPC members, such as Sushil Wadhwani, Chris Allsopp and perhaps Kate Barker, this reason is good enough to justify cutting rates.

As Mr Allsopp put it: "There is a prima facie case for a quarter-point cut if we are bothered about the symmetry [of the inflation target]."

This is music to the ears of industry and business, which gave the Bank's decision on rates a guarded welcome.

The CBI said there was still scope for a rate cut to avoid inflation falling below the bottom end of the 1.5 to 3.5 per cent band. "With manufacturers still under pressure and the service sector not yet out of the woods, this would give the economy the boost it needs," its chief economist Ian McCafferty said.

However, this strategy would also alarm the IMF. "In considering any further monetary easing, the authorities should be especially mindful of the risk of an excessive rise in debt ratios with the attendant possibility of a disruptive demand correction if consumers retrenched in the face of rising indebtedness," it said in typical IMF-speak.

A more colourful interpretation can be left to JP Morgan's Mr Gabay who, picking up on the Governor's nocturnal metaphor, said simply: "Wake up Sir Edward!"