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Why the Bank of England should have raised rates

Interest rates were kept on hold at 4.75% this month, but further hikes are needed, says Cris Sholto Heaton. And not just to tackle inflation.

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The war against inflation continued with no surprises on the interest rate front yesterday. As expected, the European Central Bank hiked again to 3.25%, while the Bank of England stayed on hold at 4.75%.

Next month, the positions are likely to be reversed. There was no mention of "vigilance" in the statement by ECB chairman Jean-Claude Trichet. In the past, this codeword has always been present the month before a rate hike. As a result, a rise in November would be a major shock, given that the ECB prides itself on how well it signals its intentions in advance.

With the BoE, the situation is different. A November hike is seen as a near certainty by the markets and it would take some terrible economic data for the bank not to oblige. But beyond this, the outlook gets a bit murkier

The ECB is clearly biased towards more increases. It's very probable that European rates will rise to 3.5% in December and, despite the wishful thinking of a few doves, this will not be the end of the campaign.

Trichet's statement was more hawkish than expected, particularly when discussing inflation. He dismissed the recent fall in headline inflation as being a temporary effect from volatile oil prices. Risks remain "clearly on the upside".

That's not the tone of a man considering one final assault before calling a ceasefire. The impression it gives is that the ECB wants to push on to 4% at least. Trichet's colleagues appear to be standing firm behind him; like us, they're more concerned about the dangers of runaway inflation that result from cheap credit and excess liquidity than they are about the squeals from over-indebted businesses and property speculators.

But the BoE is in a rather different situation. There are a number of very dovish members on the Monetary Policy Committee, most notably David Blanchflower, who bizarrely considered voting for a cut last time. And Andrew Sentance, the latest addition, is also expected to lean towards lower rates, given his background in industry. With so many changes to the committee recently, economic pundits will be scrutinising the next set of minutes even more closely than usual for hints on future decisions.

Nevertheless, other members, including governor Mervyn King, have a more hawkish slant. In fact the hawks still have a narrow majority and this should enable them to push through further increases if these are needed. And we think they will be.

The high level of consumer price inflation - which the Bank reckons could reach 3% by the end of this year - is of course, one of the main reasons that rates need to keep rising. But another major problem for the BoE is the fallout from the still-baffling decision to cut rates in August 2005. This convinced many property speculators that the Bank will always cut rates to bail them out if the market runs into trouble - which explains why the property bubble seems to have reinflated itself this year. A substantial proportion of people believe that 'the Government would never let house prices fall.'

Economists call this moral hazard'. In effect, letting people believe that someone will step in to stop them from failing encourages them to take more risks. A good example was the decision to coerce private banks into helping out hedge fund LTCM in 1998 rather than let it collapse. That decision may have convinced some banks and funds that it's fine for them to take ever-larger, riskier bets on the basis that if they go wrong, they too will be deemed too big to fail'.

If there were no consequences to this constant bailing out, then this would all be fine. But of course, there are always consequences. If you allow people or institutions to get ever-deeper into debt and more heavily into risky positions, you will eventually reach a point where the financial system gets overwhelmed, and a bail-out becomes completely impossible.

So it's important not to allow this to happen. The trouble is, once people start to believe there's a safety net to catch them, it takes a nasty fall to convince them otherwise. A rate hike this month would have been just the sort of fiscal slap that might have brought investors and property buyers to their senses without too much longer-term fall-out.

But as it stands, markets are already prepared for the rate hike in November - and that's why it is highly unlikely to be the last hike in this cycle.

Turning to the markets...

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The FTSE 100 closed above 6,000 for the first time in five months yesterday, boosted by takeover talk surrounding blue-chip stocks Corus, Ryanair and power group Viridian. The index closed 38 points higher, at 6,004. For a full market report, see: London market close

Elsewhere in Europe, the Paris CAC-40 ended the day at 5,228, a 31-point gain. In Germany, the DAX-30 closed 28 points higher at 6,075.

Across the Atlantic, stocks also ended higher. The Dow Jones recorded yet another record high close as Caterpillar Inc. made a gain of over 4%, propelling the industrials index 16 points higher to 11,866. The tech-rich Nasdaq was up 15 points to 2,306, whilst the S&P 500 ended the day 3 points higher at 1,353.

In Asia, the Nikkei paused following a week of stellar gains, ending the day 13 points lower at 16,436.

Crude oil was back above $60 this morning, last trading at $60.02. In London, Brent spot was at $59.29 a barrel.

Spot gold edged lower overnight after making gains in New York late yesterday, and most recently traded at $570.50/oz.

And in London this morning, budget airline Easyjet announced that full year profits would be slightly ahead of guidance on the back of a strong performance in September. Revenue had risen 21% to 1.62bn, whilst fares gained 7.8%. Shares in Easyjet were up by as much as 14p this morning.

And our two recommended articles for today...

What's the best way to play the water shortage? - The searing heat of July may be a distant memory as we enter a wet October, but the threat of a global drought is still very much with us. Investors are eager to capitalise on this new trend, but the most obvious ways to play the water shortage are not necessarily the best, says John Stepek. If you'd like to know which investments will benefit the most, click here: What's the best way to play the water shortage?

Could the US consumer slowdown rebalance the world economy? - As the US housing bubble deflates, all the signs point to a US consumer spending slowdown. But it's not all bad news, says economist Stephen Roach, it could lead to a much-needed global rebalancing. To find out whether the developing world is ready to fill the consumption gap - and how long a developed world slump could last - see: Could the US consumer slowdown rebalance the world economy?

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