Why the Bank of England should raise interest rates

published 9 October 2007

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Interest rates are continuing to rise across the globe. With inflation above forecasts in most countries, it's no surprise that central banks are getting twitchy.

The Reserve Bank of Australia raised the country's key interest rate this morning. It now stands at 6%, the highest it's been in nearly six years.

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The European Central Bank is seen as almost certain to raise rates this week, to 3%.

But even though UK inflation is well above the Bank of England's target level, a majority of economists still expect the key rate to remain at 4.5% when the Bank announces its latest rate decision tomorrow.

Needless to say, we think they're wrong...

Global interest rates may be on the rise, but in real terms they are still extremely accommodative.

As Australia's The Age newspaper pointed out, although Australian rates may seem high at 6%, "they remain near historical lows when measured against inflation."

With Australian consumer price inflation (CPI) sitting at 4%, real interest rates are still just 2%. This might help to explain why total consumer credit rose at an annual rate of 16% during the first half of the year.

Australia's far from being the only country with low real interest rates.

When you exclude CPI at 2.5%, the UK's real interest rate is also just 2%. That's the lowest it's been since National Statistics started measuring the CPI figure in 1997.

Small wonder that the amount of money flooding the economy continues to soar M4 money supply growth came in at an annual rate of 13.7% in June, the highest since November 1990.

Just like water, money has to flow somewhere. If the economy isn't growing rapidly enough to accommodate all that extra money, then the surplus leads to inflation. This is part of the reason that the prices of property and other trophy assets, like art and racehorses, have been pushed so high.

And yet the majority of commentators are still predicting a rate freeze when the Bank announces its decision on interest rates tomorrow.

This doesn't seem to make any sense. And indeed, the only reason that The Sunday Times could find for the Bank not to hike rates is "because it has not prepared the markets to do so."

But unless the markets have been asleep for the past month, they should have gathered by now that there are plenty of good reasons for the Bank to raise rates.

At 2.5%, CPI is well above the Bank's central target rate of 2%. And it doesn't look likely to come down any time soon.

Gas, fuel and electricity prices are continuing to surge. And rising prices are steadily being pushed up the supply chain.

The latest Chartered Institute of Purchasing and Supply survey of the manufacturing sector showed that both input costs and output prices (the price manufacturers charge for their goods) in July rose at the fastest pace in more than 18 months.

If this starts to translate into higher prices in the shops as Marks & Spencer chief executive Stuart Rose hinted at earlier this year (for more on this, see: Bad new on inflation from Marks & Spencer (/file/15207/bad-news-on-inflation-from-marks--spencer.html)) - then consumers may well start to demand higher wages. This so-called second round inflation is very hard to curtail once it has begun - which is why central banks prefer to nip it in the bud.

Things aren't any better on the other side of the Atlantic either. US core consumer inflation hit an 11-year high in June. Consumer prices excluding food and energy rose at an annual rate of 2.4%, the highest since April 1995. That's well above the Fed's comfort zone' of 1% - 2%. (Oh, and for those who need to eat and control the temperature of their homes, headline consumer prices were up 3.5%).

Rising rates in the US and the rest of the world make it harder for the Bank of England to resist following suit. If rates remain on hold here and rise elsewhere, it puts pressure on sterling to fall - and a lower currency means imported inflation.

And as if these warning signs weren't enough for the Bank, the shadow' Monetary Policy Committee, which meets under the auspices of the Institute of Economic Affairs think tank, voted 5-4 to raise rates this month.

We'll be surprised if the real MPC doesn't follow suit.

You can read more about the return of 'the inflation monster' - and how you can protect yourself from it - in this week's issue of MoneyWeek (out on Friday). If you're not a subscriber yet, you can get access to all the content on the MoneyWeek website and sign up for a three-week free trial of the magazine, just by clicking here: Sign up for a three-week free trial of MoneyWeek. (/file/194/subscribe-from-not-logged-in.html)

Turning to the stock markets...

The FTSE 100 fell 47 points to 5,880. Cairn Energy and BG Group were both ahead as crude oil prices advanced. For a full market report, see: London market close (/file/16214/london-close-mining-slide-aids-footsie-decline.html)

Over in continental Europe, the Paris Cac-40 closed 61 points lower at 4,948. The German Dax-30 fell 85 points to 5,596.

Across the Atlantic, US stocks fell back, as strong economic data and rising inflation raised fears that interest rates will rise again. The Dow Jones Industrial Average shed 60 points to close at 11,125, while the S&P 500 fell 6 points to 1,270. The tech-heavy Nasdaq dropped 29 to 2,061.

Interest rate fears weighed on Asian markets too. The Nikkei 225 fell 114 points to 15,326, with exporters such as Sony among the main losers. Australia's S&P/ASX 200 also fell, shedding 49 points to 4,931 as the Australian central bank hiked rates to 6%, a near-six-year high.

Oil prices were higher in New York this morning, with crude trading at around $75.35 a barrel. Brent crude was also higher, trading at around $76.25.

Meanwhile, spot gold was sharply higher, trading at around $650 an ounce amid rising oil prices and a volatile dollar. Silver was also ahead, trading at around $11.72 an ounce.

And in the UK this morning, banking group Lloyds TSB has just beat City profit forecasts, posting pre-tax profits of £1.75bn for the first six months of the year. But bad debts have soared, rising to £800m, up 20% on the year before.

And our two recommended articles for today...

Is the US facing recession?

- A recent survey of fund managers showed that they were more pessimistic about the state of the world economy than at any point in the past 10 years. And if America is anything to go by they are right to be worried, says Merryn Somerset-Webb. But pick the right markets, and you could turn stock market misery into a great buying opportunity. To find out how, read: Is the US facing recession?

Why gold and energy are still the best investments

- The global economy is heading for a hard landing, say John Robson and Andrew Selsby of RH Asset Management. But gold and energy are both good long-term investments that are set to survive a global slowdown. To find out which gold and energy funds you should put your money in now, read: Why gold and energy are still the best investments

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.