Rise in interest rates feared as MPC meets

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The Independent Online

Bank of England policymakers meet this Thursday amid fears that they will soon be forced to raise rates because of sharp increases in inflation.

At the last meeting of the Bank's Monetary Policy Committee, there was a swing in opinion towards a so-called hawkish view of the economy, and two of the members voted for an increase in the bank rate from 0.5 to 0.75 per cent. According to the published minutes, others viewed the decision as "finely balanced" while one wanted to pump more money into the economy.

The official borrowing rate has been at a 315-year low since March 2009, and the bank suspended its "quantitative easing" programme – the direct injection of £200bn into the economy – in November of that year.

Although far below "normal" levels, a rise in rates now, at a time of renewed frailty in the property market, could have calamitous effects on house prices and wider consumer confidence.

Broad estimates from the Council of Mortgage Lenders suggest that a 0.25 per cent increase in rates – widely expected to arrive by the end of the autumn – would cost the average British mortgage-holder around £40 extra per month. Though modest in itself, it would be the first in a run of such rises before interest rates returned to normal, and would reverse the hundreds of pounds per month in savings many benefited from as the Bank drove rates sharply lower in 2008 and 2009.

It would also be an unwelcome blow to many households undergoing an almost unprecedented squeeze on their finances and living standards , as inflation erodes the purchasing power of their salaries, wage rises remain low and tax increases further eat into spending power and confidence.

The Institute for Fiscal Studies recently said that average families would be about £500 worse off a year as a result of the Government's efforts to raise funds to reduce borrowing.

The Governor of the Bank, Mervyn King, has warned that inflation on the CPI measure would rise to between 4 and 5 per cent, and implied that it would not return to its official 2 per cent target until later in 2012.

When the latest data are published it could show CPI jumping from 3.7 per cent to 4.5 per cent, a two-year high and the fastest acceleration in more than 20 years.

On the older Retail Price Index, still widely used for pay bargaining, the rate of inflation may peak even higher. Soaring global prices for food and oil and rises in VAT have been the main driving forces behind resurgent inflation. Even since the Governor spoke, events in Egypt have driven oil prices above the "psychological barrier" of $100 a barrel and the United Nations Food and Agriculture Organisation has announced a record high for world food prices.

Such evidence of rising inflation has been matched, in part, by evidence of strength in the UK economy. While the fourth quarter of 2010 showed a shock contraction of 0.5 per cent in GDP, more recent survey evidence from businesses suggests a robust rebound, though the official figures will not be published until April.

Much will depend on how quickly mortgage lenders decide to pass on the increase in rates to borrowers and savers.

Data from the Bank of England suggest that around 68 per cent of the mortgage stock is at floating rates, while 32 per cent is on fixed rates. Among the floating-rate stock, however, there has been a shift towards borrowing at rates not strictly tied to the bank rate, and the relationship between high street rates and the Bank's policy rate has also somewhat loosened.

So far in the recession the dramatic falls in bank rate have not been matched by similar falls in the rates facing existing and new borrowers, while savings rates have dwindled to almost nil. If recent experience is anything to go by, the banks and building societies can be expected to ramp up lending rates rapidly and leave savings rates constant.

Such attempts by banks to preserve their profit margins and rebuild their capital strength will inevitably be met by claims of "profiteering" – which are especially damaging when they are due to begin a £7bn bonus bonanza.

The typical estimate for bank rate among City economists is for a hike to 0.75 per cent by the end of the year.