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Bank's move sparks debate

The main event in the UK recently has been the Bank of England’s Monetary Policy Committee’s decision to raise its benchmark interest rate by a quarter of a point to 3.75% last month – a move that was widely expected.
And November saw the benchmark FTSE 100 index in the 4,400s – its highest level since August 2002.
“The MPC’s rate decision came as a surprise to few,” says Andrew Clare, financial economist at Legal & General Investment Management. “The strength of the consumer borrowing numbers in the UK and the improvement in the global economy over the last couple of months, meant that the MPC were always likely to take back the June rate cut, which they described at the time as being a ‘precautionary move’.”
Clare adds: “We expect that they will raise rates to 4% over the next couple of months, hence taking back the rate cut earlier on in the year too. After this we believe that the MPC will take a much more cautious approach, for at least two reasons. Firstly, because consumer debt levels are high currently, they do not need to raise rates as rapidly as they may have needed to in the past to get the same ‘bang for their buck’. Secondly, they will also be conscious of the potential impact that rate rises might have on sterling. A strengthening pound is the last thing that the UK’s manufacturing sector needs after a two-year industrial recession.
“Overall, we think it very unlikely indeed that base rates will rise to the sort of levels implied currently by the money markets.”
Bank of England governor Mervyn King says: “Following a weak first quarter, output in the UK has grown at around its historical average, and inflation has now been above the 2.5% target for almost a year.
King says that inflation is “expected to remain close to the target” of 2.5% – but steady growth and diminishing spare capacity should see a gradual building of underlying inflationary pressures. He says the first interest-rate rise for almost four years “was necessary to keep inflation on track to meet the target”. He sees a “marginally softer” outlook for exports due to the weakness in the euro area.
Given soaring consumer indebtedness, King says that the Bank has commissioned a survey to improve its knowledge of the situation. “Everyone needs to think carefully about the amount of debt which they can afford,” he says.
Haydn Davies, chief economist at Barclays Global Investors, says money-market futures imply that the Bank of England will raise rates from 3.75% to 4% by the end of the year, and to 5% by the end of next year.
He points to the fact that the MPC is not fully convinced that the global recovery can be sustained and that recent revisions to the official statistics have painted a much weaker picture of consumer spending this year than was originally thought to be the case.
“For the whole year, consumer spending has been growing more slowly than workers’ take home pay because higher taxes have meant that most households have less to spend in real terms than they did a year ago.
“The growing hole in the government’s finances means that even the ever-optimistic Chancellor of the Exchequer may have to raise taxes again as early as next year.”
And Davies is worried about the level of consumer debt. “Finally, given the magnitude of the debt that consumers have built up in recent years, borrowers are far more sensitive to a higher cost of borrowing and even a small rise in interest rates is likely to have a noticeable impact on spending.”
Rick Lacaille, chief investment officer at State Street Global Advisors in the UK, says: “UK companies are reporting high levels of profitability, based on the top down economic data. It is also evident in company earnings although for many of them the pension funding situation will act as a dampener.
Lacaille adds: “UK equities look quite cheap or fairly valued compared with gilt edged or US equities and have underperformed most markets this year. The UK bond market has not really reacted very much to the growing government deficit, the public sector inflation rate and the declining chances of early euro entry. These are reasons to avoid the UK bond market, even though current inflationary pressures appear low.
“There are, of course, many willing buyers of UK bonds in the pension fund community, but they may become more discriminating as the supply increases and their solvency pressures ease.”
Retail sales grew at their slowest pace in seven months in October, according to the British Retail Consortium. “It is too early to tell whether this is a more dramatic than usual pre-Christmas pause or the start of the consumer economy running out of steam,” says BRC director general Bill Moyes.
John Hawksworth, head of the macroeconomics unit at PricewaterhouseCoopers, says there is no need for interest rates to rise any further. “The economic recovery remains in its early stages and inflation is under control, so there is no need for a major shift in the monetary policy stance at this stage.
“Indeed there is a case for leaving rates on hold for the moment until more information becomes available on the strength of the upturn.”
And he says that Chancellor Gordon Brown faces some tough decisions ahead. “Our figures suggest that, if the Chancellor is to retain credibility with the financial markets, he is unlikely to be able to avoid taking tough decisions on tax and spending at some point.”
Unemployment is at 5%. “The UK has the highest employment rate and lowest unemployment rate of the big seven industrialised countries,” says Minister of Work Des Browne.

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