Jeremy Warner's Outlook: Rates are heading higher, but that doesn't mean the Bank has lost control of the rudder

Vested interest in the airports row; Thames Water goes under the hammer
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The Independent Online

Mervyn King's inner hawk has returned with a vengeance since I went away on holiday two weeks ago. The Bank of England has unexpectedly increased interest rates, while the Bank's quarterly Inflation Report published last week left little doubt that there will need to be at least one more hike if the inflation target of 2 per cent is to be met two years out.

The Bank of England Governor has meanwhile conceded that in the short to medium term inflation may breach 3 per cent, forcing him to write a formal letter of explanation to the Chancellor.

Little in yesterday's clutch of economic statistics would lead you to the view that inflation will in fact exceed that threshold; factory gate prices remain almost unbelievably subdued and house price inflation seems to be abating again, although evidence on this is conflicting. Yet higher utility bills and the effect of the drought on fresh food prices might force inflation perilously close.

There is in any case a growing body of opinion which disputes the credibility of the official measure of inflation. Many of us are experiencing much greater inflation in our cost of living than the Consumer Price Index reflects. Unless you happen to be buying a new car, a flat screen TV, or are indulging in lots of low-cost air travel, you would be more than justified in believing that the inflationary genie is well and truly out of the bottle.

The CPI is based on average spending patterns, so it ought to be as good a measure as there can be of prices in the wider economy. Yet it still contains no element to reflect house prices - for the vast majority, the biggest purchase of the lot. In any case, perception is nine-tenths of reality, and if growing numbers think prices and charges are rising more rapidly than the CPI says, the official inflation target may no longer carry much weight.

Whatever the reasons for the Bank's change in stance, it has certainly caught most of us on the hop. The last published minutes of the Bank's Monetary Policy Committee were distinctly dovish in tone, and certainly gave no reason to believe that there was any imminent threat of an interest rate rise. Has the Bank been caught napping? Minutes to the latest meeting, the one which decided to increase rates, are published tomorrow, and will make fascinating reading.

Now, although these are all weighty matters to the cognoscenti of monetary policy, and are of vital interest to the capital markets, where fortunes are won and lost on the tiniest movements in bond, currency and stock prices, their wider significance may have become overstated.

Interest rates at 5 per cent, inflation at 3 per cent! The shock horror of the headline writers suggests a return to the pandemonium of past economic cycles where rip-roaring inflation would prompt dramatic increases in interest rates, plunging the whole economy into deep recession.

The fact that everyone can get so worked up at the prospect of inflation rising a "mere" 1 per cent above target shows how far we have travelled since the bad old days of boom and bust which characterised much of Britain's post-war history.

A rate of inflation that strays significantly from target is plainly something we should all worry about, but in the scale of things the differences are fairly marginal. The same is true of interest rates. At the present level of 4.75 per cent, rates cannot be seen as "high" by historic standards. It was only a year ago they were cut from this level to 4.5 per cent. Go back to February 2000, and the bank rate hit 6 per cent. Throughout much of the Eighties and early Nineties, it was in double figures.

The truly remarkable thing about the present cycle is not that inflation and rates are rising, but that despite oil and commodity prices at record levels, they have risen so little.

This may have had something to do with better macroeconomic management by governments and central bankers, but it is largely accounted for by globalisation and technology, which have made previously closed, developed economies subject to competition from the under-utilised labour forces of the Far East, India and eastern Europe. As for the UK economy, it is not yet time to hit the panic button. To use the language of central bankers, the outlook is still for steady growth and low inflation, or relatively low inflation at least.

Vested interest in the airports row

I'm suspicious of the shouting match being conducted between airlines and Britain's main airport operator, BAA. When you are abusing your customers to this extent, it is only natural to want to blame someone else. So the airlines blame BAA for not being able to cope with the new security measures, leading to long delays and cancelled flights, while BAA, privately at least, accuses some airlines of using the situation as an excuse to axe flights that would in any case have been uneconomic.

In situations like these, everyone suffers; the passengers suffer, confidence evaporates, profits tumble. Seeking to blame each other for the chaos hardly helps. The priority for both should surely be the safety of customers, which requires co-operation. Not much chance of that in the present fisticuffs.

But if you want to know the underlying reason for the row, just follow the money. Michael O'Leary, chief executive of Ryanair, has never made any secret of his contempt for BAA, which he regularly accuses of hopeless inefficiency and gold plating of largely unnecessary investment projects. He is now joined by Willie Walsh, chief executive of British Airways, who has become even more outspoken in his criticisms of the airport operator, if that were possible.

Both have a particular interest in exploiting the present mayhem. BAA is subject to two separate reviews: a Civil Aviation Authority review of its landing charges, and an Office of Fair Trading investigation into whether it should be broken up into separate airports to encourage greater competition.

BAA's apparent inability to manage the sudden imposition of much harsher security arrangements, particularly at Heathrow, is all powerfully supportive of their view that the company should be cut down to size. It also perhaps supports BA's case for more capacity at Heathrow. BA is considering whether to sue for compensation. A cynic would say the present chaos suits the company's long-term ambitions just fine, especially as it might end up harming the economics of low-cost rivals.

Thames Water goes under the hammer

Thames Water has become undisputed holder of the title of Britain's most hated utility - the competition is generally tough, so it took some doing - but that hasn't prevented private equity from queuing up to buy the company. There are said to be at least three private equity players preparing bids for today's deadline.

For RWE, the present owner, the advantages of a straight financial sale over the previously preferred option of a stock market flotation are obvious. RWE wants a clean, 100 per cent disposal. For such a large company, this would always have been difficult through a stock market listing. The way Thames has been castigated by both regulator and public alike in recent months may have made it well nigh impossible.

The regulator's well-documented aversion to anything that damages the creditworthiness of water companies may on the other hand make the debt leverage of private equity bidders an equally difficult proposition. Difficult, but not impossible.

Ofwat, the water regulator, has no powers to block a highly leveraged bid, but it will undoubtedly insist that the water utility assets are ring-fenced from the debt. This would make it impossible to secure the debt against the water utility and would also impose strict limits on the cash flow that could be used to service the debt. Such restrictions will devalue what private equity is prepared to pay, but it may still be higher than Thames would realise in a stock market sale.

j.warner@independent.co.uk

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