Interest rate forecast: more shocks ahead?

Will 2007 be another year of interest rate shocks? asks John Stepek. The Bank of England's decision to play it safe last month could have stored up trouble for the future.

The Bank of England decided to keep interest rates on hold at the start of last month - perhaps an early Christmas gift for mortgage holders and the over-indebted.

But Mervyn King and his chums at the Monetary Policy Committee might have been kicking themselves after they read the latest inflation figures. The Bank's target inflation rate - the consumer prices index (CPI) - grew at an annual rate of 2.7% in November, the highest since records began in November 1995.

Perhaps it would have been better for the Bank to play Scrooge ahead of the usual Christmas spending spree - because come January and February, an interest rate rise will be the last thing those struggling with post-Christmas spending hangovers need. But unfortunately, it may well be exactly what they get.

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Interest rate forecast: inflation is higher than it seems

It's not just CPI that's hitting new highs. RPIX (which is the retail price index, excluding mortgage payments), is now at 3.4%, the highest level since March 1993.

RPIX was the Bank of England's old inflation target. It included things the CPI doesn't, like council tax, for example. Now these days, if CPI goes above 3%, or below 1%, the Bank has to write an open letter to the Chancellor explaining why. But back then, the letter-writing was triggered if RPIX moved beyond 1% of a central target of 2.5% - in other words, if we were still using the old inflation measure, Mervyn King would be on the verge of getting his pencil sharpener out.

Arguably, he would want to avoid this. So it seems pretty fair to suggest that if we were still measuring official inflation using RPIX, interest rates could well already be higher.

Now you can argue about which measure is more effective - but it does show just how important seemingly small tweaks in statistics can be. Use the old measure, and you'd probably have interest rates at 5.25% or more already - and perhaps the irrational exuberance in the UK property market wouldnt be quite so pronounced.

But regardless of statistical mucking about, you can't avoid reality forever. There were plenty of things for the Bank to worry about in the latest inflation data. For a start, there were the reasons behind the jump in the CPI. Up until recently, rising inflation was mainly driven by rising energy prices. But now, it's being driven by - well, everything.

Interest rate forecast: life is getting a lot more expensive

Food prices are now 5% higher than they were a year ago. Clothing and furniture prices, which have been falling for years, are now almost flat year-on-year. Utility bills are still rising, despite falling wholesale gas prices. And of course, there are the usual suspects, such as hairdressing, school fees (up a massive 14% on last year), and all the other things you can't outsource to China, which continue to soar as they have been doing for a very long time now.

There wasn't even any relief from falling oil prices. Even though petrol prices fell last month, they didn't fall by even half as much as they did at the same time last year (when oil prices were easing off after surging in the aftermath of Hurricane Katrina) - so that contributed to the upward effect on CPI. And Gordon Brown's Pre-Budget Report tax top-up on petrol and air fares won't help December's CPI reading either.

Interest rate forecast: wage demands

But the biggest worry - for both employers and the Bank - will be the retail prices index (RPI). This stood at 3.9%, the highest since 1998. RPI has historically been used as the figure against which wage settlements are negotiated.

Some employers are trying to move towards CPI, but understandably, staff aren't keen to switch to a measure that excludes council tax and mortgage payments, and crucially, is more than 1% lower than RPI. And after all, why should they? Annual rises in the state pension and many benefits are calculated in line with RPI, because it's generally seen as a better measure of the cost of living. What would you prefer your next pay rise to be based on? CPI at 2.7% - or RPI at 3.9%? I know which one I'll be opting for.

And if non-militant private sector employees like me can see the wisdom in looking for a genuinely inflation-matching pay rise, I imagine my unionised public sector peers will be thinking along the same lines.

MPs are talking tough about 2% pay increases this year (while asking for around a 66% rise themselves, incidentally). But as plenty of unions have already pointed out, that's a pay cut in real terms - even using the inflation-lite' CPI figure.

Interest rate forecast: banking on a rate rise

The outcome of the January pay round will be of great interest. Maybe, after years of above-inflation pay hikes, public sector staff will be happy to take a cut. But I have a feeling that by playing it safe' on interest rates this month, the Bank has missed its last opportunity to deliver the short sharp shock that would have convinced us all that it's serious about tackling inflation. The Bank's own data which shows that public expectations of future inflation are now at a seven-year high suggests that people have no faith in its determination to rein in price rises.

And that almost certainly means that, just as happened this year, interest rates will have to go higher in 2007 than anyone currently expects. The general City forecast is for rates to rise once more in February to 5.25% - but I doubt that'll be the end of it.

First published on MSN Money (22/12/06)

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John 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. John joined MoneyWeek in 2005.

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.