Bank caused inflation rise with rate cut in 2005, says think tank

The Bank of England's embarrassingly public failure to keep inflation at 3 per cent or lower can be traced back to its own decision to cut interest rates two and a half years ago, a leading economics think tank claims today.

The widely respected National Institute of Economic and Social Research (NIESR) says the Bank's decision to cut interest rates in August 2005 was a costly mistake that inevitably led to it missing its inflation targets.

An NIESR study concludes that inflation would be a 10th of a percentage point lower now - 3 rather than 3.1 per cent - if the Bank's Monetary Policy Committee (MPC) had raised borrowing costs to 5 per cent rather than cutting them to 4.5 per cent that August.

While such an effect would have been small, it would have been enough to avoid the embarrassing requirement on the Bank's Governor, Mervyn King, this month to write an open letter to the Chancellor, Gordon Brown. Mr King was forced to explain why - for the first time since being given independence 20 years ago - the Bank had failed to keep inflation within a percentage point of its 2 per cent target.

Mr King opposed the August 2005 rate reduction, the first and only time the Governor has been outvoted on the MPC, though his letter to the Chancellor this month blamed short-term factors such as energy price rises for rising inflation, rather than Bank decisions.

"The cut in interest rates in the summer of 2005 now looks to have been a mistake," NIESR's Ray Barrell and Simon Kirby wrote in the institute's latest economic review, published today. "Expectations of inflation have risen, and the Bank's actions have not brought them down yet. Immediate action has only delayed effects, and although a rise in rates of half a point now would signal the Bank's resolve and help to put downward pressure on inflation, it would not have much impact for six to nine months."

The Bank's chief economist, Charlie Bean, the external MPC member Kate Barker and former members Richard Lambert, Stephen Nickell and David Walton were responsible for the quarter-point rate cut in August 2005. They argued that output growth had been subdued and consumer spending had slowed. A failure to reduce rates immediately might damage confidence, they argued. Rates were not raised again for a year.

The NIESR also pinned some of the blame on the Chancellor, arguing that marginally tighter fiscal policy from 2006 would have reduced inflationary pressures now. Controversially, it also added that inflation would have been lower if Britain had joined the single currency in 2001, because the euro's appreciation would have largely offset the impact of lower interest rates.

The institute's latest forecasts predict the UK economy will expand by 2.7 per cent this year (below the Chancellor's 2.75 to 3.25 per cent prediction) before slowing to 2.6 per cent in 2008 and 2.4 per cent in 2009. Inflation is not expected to fall back to target until the start of 2010, but the chances of another letter being written are "a little less than even".

It said just one more quarter-point interest rate rise, to 5.5 per cent, should be sufficient, but further action may be needed if goods inflation remains high. The Bank is expected to raise rates by a quarter point at its next meeting, on 10 May.

A separate report, meanwhile, yesterday showed a sharp rise in confidence about the state of the economy among UK companies. The Lloyds TSB Corporate Markets Business barometer revealed a net 41 per cent of firms are optimistic about the outlook, up from 29 per cent last month and more than double the survey's five-year average of 18 per cent.

Cost of borrowing takes heat out of housing market

Homeowners enjoyed another punchy increase in the value of their properties this month, but there are signs the market is finally coming off the boil.

The average price of a UK home rose by 0.7 per cent in April, according to Hometrack, the housing information business. That pushed the year-on-year rate of increase up to 6.8 per cent, the highest since June 2003.

But a breakdown of the data showed the latest increase was driven almost entirely by boom conditions in London. The annual growth rate in six out of 10 regions is less than 3 per cent, and in 56 per cent of postcode districts, prices either remained at a standstill or fell during the month.

Richard Donnell, Hometrack's director of research, said the market would cool in the second half of the year because of an increase in the number of homes for sale and stretched affordability after rises in the cost of borrowing. "We are beginning to see the impact of the three interest rate rises since August last year," he said. "Outside London, affordability pressures are beginning to bite and we are seeing a slowing in the rate of house prices growth."