How much further will interest rates rise?

As expected, the Bank of England hiked rates to 5% on Thursday. What will their next action be? It all depends on the outlook for the US economy, says Cris Sholto Heaton.

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As expected, the Bank of England hiked interest rates by a quarter of a point to 5% on Thursday, the highest they've been since 2001. The move had been flagged up for so long that it would have been a major shock had the Bank decided to hold. The main question now is what their next step will be.

Most of the attention will be on the forthcoming quarterly inflation report and minutes from the Monetary Policy Committee meeting. These will give us more clues as to whether the Bank is planning another hike in the first quarter of 2007 (as the markets and MoneyWeek expect).

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But beyond that, it's the outlook for the US economy that probably matters more...

Historically, the UK economy has a high correlation to the US. Almost all the recessions and severe slowdowns that the US has experienced in the last few decades have been accompanied by a slump in the UK. The major exception was in 2001, when Gordon Brown's public spending splurge helped prevent the UK from following the US into a brief recession after the dotcom bubble burst.

So past experience suggests that if the US goes into recession around the middle of next year, as several leading indicators suggest, the UK is likely to suffer a sharp slowdown - at least - in the aftermath. There's no prospect of a Brown boost this time around (he's spent too much already) and while it's possible that the Eurozone will be strong enough to avoid its own slump, it seems unlikely that it can accelerate sufficiently to shield its trade partners from the full impact.

Of course, if our suspicions are right, that would suggest that the BoE should be cutting rates early next year rather than raising in February. So why's that unlikely?

The problem is that, generally speaking, people don't think about a recession until it's upon them. The vast majority of economists were not predicting a US recession in March 2001; data subsequently showed that one had already begun. Whether that's because they had no fears of a recession or that they didn't want to stick their necks out and predict one is another question.

Now, you have to hope and expect that the BoE's forecasters will at least have an eye on the possibility. If they do, they won't talk about it openly, because talking about a recession is as good a way as any of hastening it. People start saving for tougher times, business scale back investment plans and asset markets tank.

But even if they are worried about it, they're in something of a bind. The inflation data is still saying that we need higher rates to curb inflation. The Bank is also keeping a close eye on broad money growth and so they should, with the M4 measure running at an annualised rate of 14.5% in September. House prices also show no sign of letting up, with the latest Halifax data showing prices rising at an annualised rate of 18% over the last quarter.

In this scenario, holding or cutting rates in the hope of averting a slowdown could allow inflation to take hold which would be even worse in the long run. So the BoE is likely to hike again, probably in February. Key factors in this decision will include any signs of inflationary pressures in wages if we see strong wage inflation in the January pay round, it should make a February hike a certainty.

However, further raises beyond that are still possible. It's probable that the US situation won't be clear-cut until closer to the end of next year. In the meantime, if the money supply is still growing too fast, housing still rampant or inflation still coming through in labour costs, it's likely that the BoE will feel the need to hike again.

At this very early stage, this most probable time for another raise (probably to 5.5%) would be May, since the MPC clearly prefers to see the latest quarterly inflation report before taking action. Thereafter, it's unlikely they'd raise again if the economy shows signs of slowing sharply. The bias would be towards cutting. But as long as inflationary pressures stay in the system, they won't be able to cut quickly enough to engineer a soft landing at least, not without storing up more trouble further down the line.

If we suffer a sharp slowdown or recession that would almost certainly pop the housing bubble in a spectacularly messy way. Of course, this may not come to pass. Maybe the US will escape recession. Maybe the UK will somehow decouple (although it's hard to see how). But don't assume that that will save the housing market for long.

Theoretically, there may be a very narrow corridor of softer growth in which the economy ticks along okay, inflation subsides and the housing market eases gently into a soft landing. But we wouldn't bet on the blunt instrument of interest rates steering us into it. If a slump is avoided, the Bank's problem is likely to be the opposite growth remains too strong and inflation too persistent.

In that scenario, the Bank will have to keep tightening until the economy slows. And given the extent to which our economy depends on debt-fuelled consumption, that probably won't happen until the housing market is well and truly under the cosh.

Turning to the stock markets...

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The FTSE 100 closed 7 points lower yesterday, at 6,231, on a day which saw a muted reaction to the Bank of England's decision to hike interest rates. Shares in ITV jumped over 6% after the broadcaster confirmed it had been approached by NTL. Investor concern as to how pharmas would fare following Democrat successes in the US mid-terms saw blue-chip AstraZeneca lead the sector lower. For a full market report, see: London market close.

Across the Channel, the Paris CAC-40 closed 11 points higher, at 5,448, In Frankfurt, the DAX-30 closed at 6,358, a 9-point fall.

On Wall Street, stocks broke their three-day winning streak as weak consumer data and higher crude prices weighed on investor sentiment. The Dow Jones ended the day 73 points lower, at 12,103, with the biggest losses made by drug stocks Merck and Pfizer. The Nasdaq was 8 points lower, at 2,376. And the S&P 500 closed 7 points lower, at 1,378.

In Asia, the Nikkei closed 86 points lower, at 16,112.

Crude oil rose to a two-week high of $61.16 yesterday on concerns over the effect of winter heating demand and Opec cupply cuts on US stockpiles. It had fallen back half a percentage point to $60.85 this morning. In London, Brent spot was also lower, at $58.98.

Spot gold hit a high of $623.50 in Asia trading today.

And in London this morning, a survey by Liverpool Victoria showed that the cost of bringing up a child is rising even faster than house prices. Parents now have to spend £180,000 to raise a child to the age of 21, 9% up on last year and up 28% in the last four years. The rising cost of education was cited as one of the major factors.

And our two recommended articles for today...

US economic growth: the great debate

- Markets are agonising over the US growth outlook once again. The Teflon-like US economy has bounced back smartly from previous periodic downshifts. So is another such bounce in the offing, or is this slowdown for real? Morgan Stanley economists Dick Berner and Stephen Roach put forward the respective arguments: US economic growth: the great debate

Does vice still pay?

- If you're feeling bearish on the economic outlook, you might want to consider the classic defensive sector: vice stocks. Civilisations may come and go, but our bad habits - drinking, smoking and gambling - endure. To find out which vices are nicest for investors, and which ones to go cold turkey on, see our cover story from Issue 298 (just available to non-subscribers): Does vice still pay?

Cris Sholto Heaton

Cris Sholto Heaton is an investment analyst and writer who has been contributing to MoneyWeek since 2006 and was managing editor of the magazine between 2016 and 2018. He is especially interested in international investing, believing many investors still focus too much on their home markets and that it pays to take advantage of all the opportunities the world offers. He often writes about Asian equities, international income and global asset allocation.

Cris began his career in financial services consultancy at PwC and Lane Clark & Peacock, before an abrupt change of direction into oil, gas and energy at Petroleum Economist and Platts and subsequently into investment research and writing. In addition to his articles for MoneyWeek, he also works with a number of asset managers, consultancies and financial information providers.

He holds the Chartered Financial Analyst designation and the Investment Management Certificate, as well as degrees in finance and mathematics. He has also studied acting, film-making and photography, and strongly suspects that an awareness of what makes a compelling story is just as important for understanding markets as any amount of qualifications.