What will the latest rate hike mean for the UK economy?

Bovvered? Well yes actually! The UK economy has, so far, performed pretty well but the latest hike in domestic base rates, by a further 0.25% points to 5.75%, whilst clearly aimed at keeping the lid on inflation, is almost certainly going to have an impact on the real economy in due course.

The 5th July decision had been widely telegraphed in advance and perhaps for as long as the previous monthly decision at which the governor voted with the minority (5:4) for an early increase. Although obviously not affecting the outcome (he votes last apparently) his move was clearly designed to signal his own desire for another base rate hike sooner rather than later over the now familiar concerns regarding capacity constraints, corporate pricing power and money supply growth. Although the result of the vote will not be known until the minutes of this latest meeting are released it seems pretty clear to us that when the governor votes with the minority he always maintains an unreservedly hawkish stance on the basis, one assumes, that the Bank's credibility might be undermined were this position to be maintained over a number of months.

The question then becomes one of how many waverers can be persuaded to change sides? On this occasion it might only have taken one and our money is on Bank chief economist Mr Charles Bean who, although voting with the doves in June, testified hawkishly to the Treasury Select Committee recently.

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5.75% interest rates: impact on growth

UK Gross Domestic Product (GDP) has proved pretty robust over the past few quarters, trending at around 0.7% (or 3.0% year on year). This would represent growth at, or close to, the top end of the long-term trend rate generally thought commensurate with stable prices and employment. In fact the domestic economy's potential might actually be a little higher than 2.5% - 3.0% given the pace of inward migration but clear anecdotal evidence from many of the companies that Charles Stanley researches does indicate that capacity constraints are indeed becoming an issue and that many are responding to ongoing strong demand by pushing price increases through. Looking forward, the critical question is how might activity levels respond to higher rates. Releases from both the Treasury and the Bank of England continue to argue that output growth will be barely affected, however, after five quarter percentage point increases within the space of a year, we do not agree.

5.75% interest rates: consumption patterns

Inevitably we think that all observers will scrutinise the consumer closely, particularly so given that consumption represents c80% of overall GDP. Thus far consumption patterns have barely been dented by the rate hikes of the past, largely the consequence of rising property prices. We note here, as many have before us, that many households will only feel the brunt of the impact on their finances when existing fixed rate mortgages come to an end.

In this context it is noteworthy how many opted to fix their mortgages during 2005 (normally for a two year period). Housing-related data shows quite clearly that the percentage of new fixed rate mortgages taken out increased from about 40% to around 80% over that twelve month period. Although a lag exists between a rate hike being implemented and its impact being felt in the real economy, the clear inference must be that home owners will begin to feel the brunt of higher base rates when they re-fix at higher rates as the year progresses.

It also takes a short while for higher base rates to impact the housing market. Recent official data points to a fall in the number of mortgage approvals for new house purchases and a decline in the ratio of sales to stock of unsold houses, implying that house price growth could slow from the current 10% year on year rate to perhaps less than 5% in 2008.

The upshot is that we would expect consumer spending to be adversely affected by higher borrowing costs and a likely slowdown in the pace of house price growth, for so many the source of recent spending power.

To some extent consumption will be supported by falling inflation, particularly so as utility prices continue to fall. However, the vast majority of opinion expects the income improvement to be more than offset by the knock-on effects of a slowing residential property market and consequent increase in the savings ratio.

5.75% interest rates: corporate sector strongly placed

By contrast, the corporate sector's balance sheet is in much more robust health than that of the consumer. Whilst higher short-term interest rates may push up debt servicing costs for some, the slide in the ratio of corporate debt to assets does suggest that most companies are strongly placed to increase investment should they so wish and recent surveys of company investing intentions do indeed suggest that investment should pick up over the coming months, albeit from pretty depressed levels.

The strength of corporate sector investing intentions is really the only bright spot for activity growth going forward. Government spending seems certain to come under pressure as the new Chancellor wrestles to bring the public finances back under control. Apart from the very vague possibility of a snap General Election, in which case all bets are off, our expectation is that a Labour administration under Gordon Brown will want to control the public purse strings and early evidence already points to falling public sector investment and employment. Meanwhile sterling's strength on the foreign exchanges, particularly against the dollar, hardly provides much encouragement for what remains of Britain's embattled export sector to say nothing regarding the possibility that external demand could ease in response to tighter monetary conditions elsewhere.

5.75% interest rates: so what?

Whilst the Bank of England's Monetary Policy Committee took its decision to raise base rates again this month on the basis of concerns regarding inflationary pressures which may or may not prove to be correct, we suspect that there will be a price to be paid in terms of real economy activity levels.

The best guess at this stage is that output growth will continue, but at a more muted pace (c2.2% in 2008 from c2.8% in 2007). If that proves accurate it might be possible to surmise that the Bank's gamble paid off. We are sure that Committee members would gladly settle for easier paced growth if they could feel more comfortable that the inflation genie was firmly back in its bottle at the same time.

One might even argue that a measured decline in the pace of growth had been planned in advance. The risks to this cosy outcome are, however, potentially significant. Given the relative importance in terms of their contribution to overall output growth, consumer spending patterns and the residential property market will be watched closely over the coming months for signs of weakness. A sharper than expected downturn in either would spell bad news.

Alternatively, the risk the other way is that companies continue to push prices higher, that the housing market remains robust and that consumers continue to participate in the wild celebratory beano more normally associated with drunken sailors just down the gang plank after a prolonged spell at sea. In such circumstances 5.75% base rates might well not be the last. We'll probably know in September!

By Jeremy Batstone, Director of Private Client Research at Charles Stanley