Don't blame Labour when the rates rise

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If Labour wins the general election, one of the first tasks facing Gordon Brown, when he replaces Kenneth Clarke as Chancellor of the Exchequer, will be ordering the Bank of England to raise base rates by half a point.

But it won't be his fault.

Judging by what the financial markets are saying about the interest rate outlook, Mr Brown will have to carry on raising rates until the end of the year, from the current 6 per cent to 7 per cent or higher. That'll push mortgage rates and consumer borrowing costs to their highest level in five years.

But it won't be his fault.

Gilts closest to maturity have taken a beating in recent weeks. Yields on two-year UK government bonds, for instance, have risen half a percentage point. The reason? Investors reckon Mr Clarke's decision last week to stand pat on interest rates only postponed the inevitable.

When traders want to bet where interest rates are headed, they turn to the interest rate futures market. According to where the futures trade now, traders bet Mr Brown will raise rates by half a point at his first meeting with Bank of England Governor, Eddie George, on 7 May.

The blame for the even higher rates that will follow, which will be designed to reduce inflationary pressures but could smother the nascent recovery in the housing market, lies squarely with the current Chancellor.

As James Barty, chief economist at Deutsche Morgan Grenfell, puts it: "Clarke has ensured that his likely successor will not have an easy time."

With the Conservatives trailing Labour in the polls, Mr Clarke has resisted Mr George's repeated demands for a rate rise this year, allowing his political instincts to dictate an unchanged monetary policy when his economic experience might have persuaded him to act. Perhaps unwittingly, he's laid a trap for the next Chancellor.

Unlike years gone by, there's little evidence the prospect of a Labour government is causing unease among foreign investors. The premium investors' demand to buy 10-year UK government debt, rather than comparable German securities, is about the same as it was at the beginning of the year at 180 basis points.

That's new. In the past, expectations that a Labour government would ratchet up public spending and be more willing than the Tories to tolerate higher inflation was enough to spark a run on the pound and a collapse in the gilt market, and to drive interest rates higher.

Now, with Labour singing from the same low-inflation hymn sheet as the Conservatives, and pledging to keep spending under control, investors aren't worried about a change of government after 18 years of Tory rule.

It's the growing strength of the UK economy this year that will force borrowing costs higher. Each month that Mr Clarke has refused to bow to central bank demands for higher rates, he's set the stage for even higher rates later in the year - a scenario the Bank of England has warned of repeatedly.

What's interesting is that the City reckons interest rates are headed higher even if the Conservatives repeat their Houdini trick of five years ago and hang on to power. If Mr Clarke clings on to his office in the Treasury, he, too, will be looking at raising interest rates to get the underlying inflation rate down from its current 2.9 per cent to the target of 2.5 per cent - a target Labour has also adopted.

BoE chief Mr George has called for higher rates to dampen inflation at every monetary policy meeting since 23 September, though he's only been successful once, when Mr Clarke agreed to raise rates by a quarter-point to 6.00 per cent in October.

At the subsequent meeting on 11 December, Mr George was refused a further quarter-point rise. By the time he met with Mr Clarke in January, he was demanding a half-point rise, a call he repeated in February.

Fund managers see little difference between the economic policies of the two parties. David Dyer, at Axa Equity and Law, said no matter which party is in office after the election, he expects to see the Bank of England get its way.

Even if the Conservative Party pulls off a shock victory in the election, "I don't think I'd dramatically alter any forecast on interest rates," Mr Dyer says. "They're being determined by the economy, not who's in power." Other fund management groups such as the Norwich Union agree with this analysis.

Retail sales surged 4.4 per cent in February, higher than the 3.8 per cent anticipated by economists. Unemployment, meantime, fell by more than 68,000, almost double the expected drop, pushing the jobless rate down to 6.2 per cent from 6.5 per cent in January.

With the economy expected to grow by 3.2 per cent this quarter, up from 2.7 per cent in the final quarter of 1996 (the most recent quarter for which official figures are available), interest rates are headed higher to stop inflation rising.

Investors are now pencilling in a rise in base rates to 7 per cent or just above this year, with inflation likely to remain above 2.5 per cent until the credit squeeze hurts. After that, rates could ease.

So, expect your mortgage payments to rise after the election, and continue rising for the rest of the year.

But don't blame Labour. Copyright: IOS & Bloomberg