Economists bet on fourth rise in rates

The economy is expanding fast enough to make it odds-on that the cost of borrowing will soon rise for the fourth month running, City economists have concluded.

Figures for gross domestic product, the widest measure of the economy, showed that it grew at an uncomfortable pace in the second quarter of the year. Although manufacturing output was flat in the three months to June, services such as management consultancy, transport and retailing are booming.

The last important official figures before the next meeting of the Bank of England's Monetary Policy Committee on 7 August, they are expected to have a crucial influence on its decision. Most City experts reckon the committee will opt for a fourth quarter-point rise in interest rates to 7 per cent despite the pain that the strong pound is inflicting on exporters.

"That might stay the hand of the committee, but it would merely delay the inevitable," said Kevin Darlington at Hoare Govett.

According to the Office for National Statistics, GDP increased by 0.9 per cent in the second quarter of the year, taking it to a level 3.4 per cent higher than a year earlier. The quarterly increase was the same as in January to March but lower than the 1.1 per cent rise in the final quarter of last year.

However, annual growth has picked up from 2.9 per cent at the end of 1996, compared with a trend rate of 2.3 to 2.5 per cent. It is widely expected to climb further as the year progresses, fuelled by the windfall building society shares, rising incomes and falling unemployment.

Full details on the latest quarter are not yet available, but total output of the service industries rose by 1.3 per cent and 4.5 per cent year on year. The growth was widespread, the ONS said, but strongest in business services such as management consultancy and computer services. Transport and communication, and distribution, hotels and catering also expanded rapidly.

In sharp contrast, manufacturing output was roughly flat in the second quarter. It fell in May, but the ONS indicated that it has recovered somewhat in June.

The unbalanced nature of the budding boom has alarmed economists. Some predict a sharp slowdown in 1998, when the windfall has been and gone, the overvalued pound finally eats into export volumes and the effect of increased borrowing costs works through.

Robert Barrie, an economist at BZW, said: "A lot of influences will slow the economy down. The effect of the strong exchange rate will be very powerful and very painful. It will have knock-on effects on the rest of the economy."

Simon Briscoe, head of research at Nikko Europe, said yesterday's figures already showed the economy growing at a slower pace than at the end of last year. "I don't think the Bank should raise interest rates, and I don't think they will in August," he said.

This was a minority view, however. Most City analysts think the MCP will continue to put more weight on the signs of buoyant consumer spending and services than on the early evidence of weaker exports and manufacturing industry.

"With the Bank's sights set firmly on the future - and in particular on the likely impact of windfall payouts on high street spending - further rises in interest rates over the coming months look certain," said Jonathan Loynes at HSBC Markets.

David Bloom at James Capel warned that the latest figures did not yet include any sizeable impact from windfall gains. "In the third quarter they should come through by the bucket-load, pushing the service sector to levels where inflation pressures will further exert themselves," he said.

Few see any hope of relief from the strong pound in the near future, although it did dip yesterday following reports that two big banks had been selling sterling. It fell to just over DM3.05 before rallying. Its index against a range of currencies ended 0.1 lower at 106.2.

The remaining figures due before 7 August - consumer credit and the CBI's distributive trades survey on the one hand and industrial output along with the monthly purchasing managers survey on the other - are not expected to alter the balance of the Bank's decision.