The Big Question: How much higher will interest rates go, and are these rises necessary?

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The Independent Online

What happened to interest rates yesterday?

That's not as stupid a question as it sounds. The headlines will say "rates went up yesterday". What actually happened was the Bank of England raised its base rate - the rate of interest it lends to the high street banks. That does not affect the person in the street. It is the banks that decide how much of that to pass on - if any - to borrowers and savers. As of yesterday evening, no lenders and very few saving banks had changed their rates.

Meanwhile, an army of traders in the City of London will also place their bets on the next move in rates. This in turn influences longer-term interest rates in financial markets that banks and building societies use to fund their lending to homebuyers and businesses. It can also help or hinder share prices and the value of the pound. Thus, as the flow chart shows, it triggers a domino effect through the economy.

Why is no one surprised by the move in rates?

This was the most predictable decision to raise interest rates than anyone can remember. Not one of the City economists paid to predict these things thought the Bank would do anything other than order a quarter-point - 0.25 percentage point - rise in the base rate to 5.0 per cent. This is partly because the Bank has developed a habit of sending out strong signals.

In the minutes of their October meeting, the Monetary Policy Committee of nine economists who set rates stated bluntly that most of them "placed considerable weight on arguments supporting a further rise in the base rate but thought there was no pressing need to raise rates this month".

What were the economic reasons for the increase?

In theory, the MPC has one job - to set interest rates so that one particular measure of inflation stays as close to 2 per cent as possible. Currently inflation is at 2.4 per cent and could hit 3.0 per cent by the end of the year.

But there is far more to it than simply raising rates when inflation is above target. Two years ago, the MPC was raising rates when inflation was as low as 1.1 per cent.

What drove the Bank to raise rates was a whole host of factors putting pressure on inflation. Top is the runaway housing market. The Bank says it does not attempt to control prices but acts to head off increases in spending that tend to follow massive rises in housing wealth.

Meanwhile, an avalanche of bonus payments is around the corner. Workers are expected to share in a £20bn bonus pool, of which half will go to City traders. Watch out for a new-year stampede to Ferrari dealerships and estate agents in Chelsea - the Bank of England will certainly be.

But even ordinary folk's pay could push up rates. Inflation-beating price rises - 27 per cent for electricity, a staggering 40 per cent for gas and 7 per cent for both health insurance and school fees - have made households feel poorer. The rate of inflation that pay bargainers use is set to hit 4 per cent, and that will feed through to the annual new-year wage negotiations.

So more rises in interest are a done deal, then?

Far from it. Just as the Bank can raise rates when inflation is low, so it can cut if it believes that the outlook is for a slowdown in inflation and growth. The financial markets expect another quarter-point rise, probably in February. But economists are divided - confirming George Bernard Shaw's joke that if all the economists were laid end to end, they'd never reach a conclusion. A poll of 58 by Reuters found 13 forecast another rise in the new year, 28 seeing no move beyond 5 per cent for the whole of next year, and 19 predicting at least one rate cut by the end of 2007.

The Bank did little to resolve that debate with the statement it issued yesterday. For every risk of higher inflation, it offered one pointing the other way. It said economic growth was strong but consumer spending was only "moderate". It said inflation would stay above target in the short term but then fall back while oil prices could start rising again after their recent sharp falls. It highlighted asset prices - code for houses and shares - but mentioned the rise in unemployment. Economists hope Mr King will use his quarterly press conference next week to shed more light.

Is it a disaster if the base rate goes above 5 per cent?

That depends who you ask. Business leaders and heavily indebted consumers might well answer in the affirmative. Citizens Advice warned more households could be "pushed over the edge" by the rise, which will mean homeowners with a £100,000 mortgage will face an additional £16 on monthly repayments. This week it said its network of bureaux in England and Wales advised on 1.4 million debt problems in the year 2005/06, an increase of 11 per cent on the previous year.

Industry, retailers and housing experts said it would cause unnecessary damage. The British Retail Consortium, for example, said it was "premature", would harm consumer confidence and lead to an economic slowdown. The National Association of Estate Agents (NAEA) said while house prices might be rising in London, there were large areas of the country where it would have a detrimental impact.

Would it have been wrong not to have acted yesterday?

The Royal Institution of Chartered Surveyors took the opposite view to the NAEA. It had urged the Bank to raise rates, saying it was better to act early rather than wait and have to inflict larger rises. Businesses hate inflation and respect the Bank for taking steps to ensure no repeats of the 1970s hyper-inflation. The Institute of Directors said without yesterday's increase, the rise in house prices would have encouraged people to borrow yet more against the value of their homes, "pouring further fuel on the inflationary fire".

Despite Citizen Advice's warning, the Alliance & Leicester's thermometer shows that rates would have to hit 8.25 per cent before homeowners would pay out the same share of their income to meet the mortgage, as they did during the 1980s crash.

Was the Bank of England right to raise rates yesterday?

Yes...

* Booming house prices, soaring utility costs and the return of pricing power on the high street all signal inflation ahead

* Inflation is a pernicious evil and if allowed to fester will require harsh measures to defeat it

* The signal that a rate rise sends is as powerful as the move itself, and will alter people's behaviour before they fuel inflation further

No...

* Inflation on the high street is low and even the Bank forecasts that headline inflation will slow

* Manufacturing growth stagnated in September, while exports fell over the summer thanks to the rising value of the pound

* High utility bills will force consumers to curb their spending without higher interest rates

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