Riddle of the next rate rise

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The Independent Online
Interest rates are going to go up again. Explaining why is easy: parts of the economy are still expanding fast enough to pose a risk of higher inflation. The difficulty is figuring out when and how far base rates - and mortgage rates - will move.

That some bits of the economy are booming stretches the credulity of the average home owner or consumer, but it is true. The recovery has been concentrated on manufacturing and exports and industrial output is growing at about 4 per cent year on year.

The latest batch of statistics, announced this week, have placed the Chancellor in something of a dilemma. They showed clear signs that economic growth is slowing. Exports have fallen in the latest three months and the number of people claiming unemployment benefits, while falling for the 19th successive month in March, was the smallest drop for eight months. The Confederation of British Industry also warned that domestic retail sales had dropped in March, the third month in a row.

But news on the inflation front was worrying and many economists reckon another nudge or two from interest rates will be needed to stop inflation heading above the top of the Government's target range. Retail price inflation excluding mortgage costs, supposed to be in the lower half of a 1-4 per cent range, was 2.8 per cent last month and is expected to rise further.

Prices further back in the inflation chain, charged by producers at the factory gate, also rose 3.8 per cent in the year to March. Higher costs are being passed on to wholesalers and retailers, who will in turn pass some of it on to their customers.

The weak pound has also fanned fears of higher inflation. It has fallen nearly 5 per cent this year, raising the price of imported goods. The rule of thumb is that, if it lasts, this fall would need to be offset by a rise in base rates of 1 percentage point.

To Eddie George, Governor of the Bank of England, this will look like a pretty convincing case for raising interest rates- especially if he thinks Kenneth Clarke will cut taxes in the next Budget. The City consensus is that base rates will go up half a point in May or June and half a point around Budget time, the end of November.

Helen Macfarlane, an economist at the City broker Hoare Govett, says: "There are obvious signs the economy is slowing, but the pressures in manufacturing are still strong." A former Bank of England official, she would not be surprised to see base rates rise when the Chancellor and Governor of the Bank meet the day after the local government elections.

Others believe the economy is already slowing enough thanks to the three previous base rate increases. Geoff Dicks at NatWest Markets argues that the strength of manufacturing is the result of a better balance of growth - away from consumer spending, towards industry and exports. He sees no overall inflationary pressure. "But rates will go up at the Budget as a quid pro quo for taxes," he says.

At the other end of the spectrum, David Owen at the merchant bank Kleinwort Benson believes consumer spending will recover from all the tax increases later in the year.

He points out that earnings are picking up sharply too - at least outside the City, where bonuses are much lower this year than last. He says: "Add in the political pressure to announce tax cuts, and it all points to an extended period of rising interest rates."

On balance, it is safe to predict another increase or two this year, with the first perhaps as early as 5 May. Two half-point moves would take base rates to 7.75 per cent, the highest since October 1992.

But mortgage payers can comfort themselves with two thoughts. One is that lower inflation will mean a much lower peak in base rates this time - probably in single figures. There will be no return to the giddy heights of 15 per cent seen in 1990.

The second is that building societies do not raise mortgage rates as fast as base rates. With the housing market so weak, the societies may still take it on the chin and cut their margins instead.