Outlook: The pointy heads are wrong on rates

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THE MONEY markets reacted to the Bank's decision yesterday not to raise interest rates from their present level of 5 per cent by pricing in even bigger increases in the next few months than they had originally been expecting.

Short sterling futures are now pointing to a base rate of 7.5 per cent by the end of next year, while a quarter point rise next month in the cost of borrowing is viewed as a racing certainty.

Yet, in contrast, 26 out of 28 City pundits, who are employed by the self-same investment banks as these trigger happy currency dealers, said they did not expect a rate rise this year. The economists reckon they are right and the markets wrong.

Even if the official house view is that rates will stick at 5 per cent, somebody down the corridor has made the calculation that if the pointy- heads are wrong, they are wrong in an obvious direction.

Their short sterling bets can be seen as insurance against the probability that rates will rise rather than stay the same. They are certainly not going to fall.

But the economists' confidence is bizarre anyway. In the latest month all the evidence has been of faster than expected growth and more momentum in the economy. The exchange rate, an important reason inflation has stayed subdued, has started to fall. House price inflation has accelerated sharply.

At the same time the case for arguing the UK has begun to enjoy a US- style "new era" of fast growth and slow inflation is being undermined by signs of slower growth and faster inflation across the Atlantic. There is a good chance of a rise in US rates later this month.

On the other side of the scales sits the solitary fact that the inflation rate, on both headline and target measures, will decline further between now and Christmas. Given this backdrop, any increase in interest rates would, on the face of it, look odd.

But, as any City economist will tell you, this month's inflation reflects the pressure of demand a year or two ago. The Bank has to look forward. With little spare capacity thanks to the gentleness of the slowdown, the Monetary Policy Committee will have to raise rates pretty promptly as soon as it is sure the economy's growth has returned to trend. They might not go as far as the markets think, but rates will start to rise sooner than we think. Industry will bleat, but not those who have managed to lock their mortgages in at the present base rate.