Surprise as interest rate is raised

Homeowners were dealt a New Year blow today after a shock decision by the Bank of England to raise interest rates for the third time since August.

The Bank's Monetary Policy Committee (MPC) increased the cost of borrowing from 5% to 5.25%, making mortgage and loan repayments more expensive for millions in the UK.

It was widely thought that rates would stay on hold today, with the markets and some economists forecasting a rise next month.

But with inflation currently running well above the 2% target at 2.7% and set to rise further, the MPC hiked rates today.

Policymakers are concerned at the strength of the housing market and the prospect that wage deals settled this month could fuel inflation further.

Economist Malcolm Barr, of JP Morgan Chase Bank, said: "The surprise value of a move today may be seen as an opportunity to derive more bang per buck from the move, with a view to sending another message to wage negotiations currently in train."

CBI chief economic adviser Ian McCafferty said: "It is disappointing that, with only tentative indications about the outcome of the wage round, the Bank has already decided to increase interest rates.

"If part of the intention was to dampen wage increases, it is doubtful a rate rise will have the desired effect.

"Unless wage settlements pick up steeply in coming months, inflation is set to fall back towards the Bank's mid-point target of 2% during the second half of 2007. The economy is already expected to slow over the course of the year."

The Bank of England said in a statement: "In the United Kingdom, output continues to rise at a firm pace. Domestic demand has grown steadily and credit and broad money growth remain rapid. The international economy continues to grow strongly.

"Sterling has risen and oil prices have fallen back. But the margin of spare capacity in the economy appears limited, adding to domestic pricing pressures. CPI inflation was 2.7% in November.

"It is likely that inflation will rise further above the target in the near term, but then fall back as energy and import price inflation abate. Relative to the November Inflation Report, the risks to inflation now appear more to the upside.

"Against that background, the committee judged that an increase in Bank Rate of 0.25 percentage points to 5.25% was necessary to bring CPI inflation back to the target in the medium term."

The Bank of England decision to put up rates by 0.25% to 5.25% is likely to cost homeowners with a typical £100,000 mortgage around £16 a month.

If lenders pass on the full hike in rates, monthly repayments on an £100,000 loan will increase from £706.77 to £722.80, based on a new mortgage rate of 7.25%.

The announcement had an immediate impact on the stock market, with the FTSE 100 Index losing earlier gains to stand marginally in negative territory.

Housebuilder Persimmon stood 2% lower, while lenders Northern Rock and Halifax Bank of Scotland were down by a similar amount.

Economist Philip Shaw, of Investec Securities, said fears over strong increases in the wage round prompted today's decision.

"The Bank is concerned about early signs that the pay settlements in January have been firm and it wants to send a strong message out that it wants to meet the inflation target in the medium term," he said.

Mr Shaw said it was hard to tell which way the next move will be, given today's shock decision and the surprise hike in August.

"Our guess is that there's not too much of a medium-term inflation problem but in terms of the MPC's movements over last year in surprising markets on two occasions, you cannot rule out further moves in the future."