Return of the Bank's rate setting dilemma

House prices are still rising and retail sales are booming but manufacturing industry continues to plunge deeper into recession
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The Independent Online

As a consensus grows that interest rates in the UK are close to their trough for the cycle, the Bank of England yesterday received a stark reminder of the dilemma it faces as its Monetary Policy Committee starts its two-day meeting today.

Britain is still bedevilled with its two-speed economy, despite the turmoil of the last year that saw the world's three largest economies – the US, Japan and Germany – slip into recession,

Fresh figures yesterday hammered home the scale of the divide showing that the housing market surged last month while engineering companies slid further into recession.

Halifax said house prices rose almost 3 per cent in December alone, taking the average property price to £98,885. This was equivalent to a paper windfall of £2,752 or £90 a day.

This took the annual price gain to 15.5 per cent. Against that background it is not surprising consumers are happy to spend.

With mortgage rates at their lowest since 1955 homeowners have sought to turn their paper windfalls into cash by remortgaging their property – a process known as mortgage equity withdrawal.

Figures for the third quarter of 2001 showed that MEW rose at the fastest rate since the height of the Lawson boom, by drawing down a total of 4.9 per cent of their post-tax income. And that was before the further 0.75 per cent of rate cuts in the fourth quarter.

On top of that, consumers now carry a record amount of debt thanks to low interest rates, allowing them the freedom to spend – but exposing them to risks if interest rates rise.

That translated into a bumper Christmas for retailers, who reported their best December sales since 1987, according to the survey by the employers' group CBI.

Halifax expects the runaway housing boom to slow over the year to about 5 per cent as slowing economic growth and rising unemployment crimp people's willingness to pay high house prices.

But Halifax forecast 4 per cent house price growth for 2001 and some economists are starting to revise up their forecasts for consumer spending this year, pointing out that it has a tendency to overshoot analysts' expectations.

Gary Styles, head of economics at Halifax, said 2001 has been a "remarkable" but he said it was difficult to see a repeat this year.

"We are starting to see unemployment rise, albeit slowly, and we are starting to see much softer house price figures for London and the South-east which leaves a lot of work for other regions to pick up the baton," he said.

He added that even if consumer spending continued to accelerate then Sir Edward George, the Governor of the Bank of England, had made it clear he stood ready to raise interest rates. This would slow the housing market by reducing the affordability of property.

But talk of interest rate rises has triggered consternation and anger among industry groups. The Engineering Employers Federation yesterday said the outlook for manufacturing continued to be grim.

Its believes engineering will contract another 2 per cent this year following a slump of 3.2 per cent in 2001.

The EEF blamed weak global demand, the fall in aerospace demand after 11 September, the strength of the pound and fierce competitive pressures.

It warned that firms would respond by cutting jobs and investment. EEF believes 160,000 manufacturing workers, including 80,000 engineers, will lose their jobs this year.

Martin Temple, the organisation's director-general, urged the Bank of England to ignore the "siren voices" in the City calling for rate hikes to quell an inflationary boom on the high street and in Acacia Avenue.

"We need to hold the position and, if anything, the circumstances would suggest a cut rather than an increase," he said.

Ian McCafferty, the CBI's chief economist, agreed pointing out the inflation target – the Bank's key criterion – was not under threat. "Even where activity is stronger, such as on the high street, it is clear there is little sign of inflationary pressure," he said.

The MPC is likely keep rates on hold at 4.0 per cent at noon tomorrow. Any other decision would be an embarrassing surprise to the 28 economists polled by a news agency, all of whom predicted no change.

But for Malcolm Dunphy, the chairman and managing director of Dunphy Combustion in Rochdale, low interest rates is only a small help.

"The UK is the most hostile environment in Europe in which to be a manufacturer, without any doubt," he said.

He has cut the workforce at his £7m-a-year company that makes high-performance combustion equipment by 15 per cent over the past two years.

He said he was strongly in favour of joining the euro. "I don't know why we have not committed to it sooner," he said.

The EEF believes the pound will now fall against the euro from €1.60 at the end of last year to €1.44 by 2004 – a 10 per cent devaluation. Most manufacturers would trade that sort of competitive advantage for higher interest rates.

But the MPC has stated it cannot target exchange rates andit would be hard to do so.

Instead it has followed a clearly stated policy of stimulating the parts of the economy that it can affect by cutting interest rates to a four-decade low in order to prevent the global recession spreading to the UK.

As Mr Temple said: "One of the things that have helped manufacturing is that people have continued to consume and we should be careful not to give an overly precipitous reaction when things are already fragile."

In other words – two speeds are better than none.