Why higher interest rates are a necessary evil

This month's interest rate rise came as a nasty shock to the markets. Although estate agents and business lobbyists are unhappy with the decision, the stream of cheap credit had to be cut off at some point.

This month's interest rate hike came as a huge - and unpleasant - surprise to the markets.

The Bank of England (BoE) hiked the key UK interest rate to 4.75%. It was the first move since August 2005, when the BoE cut the rate from 4.75% to 4.5%.

The FTSE 100 plunged nearly 100 points after the move was announced. Bond yields jumped as the price of gilts fell, and sterling bounced a full cent against the US dollar.

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Interest rate rise: market turmoil

Why the turmoil? Because most economists had been expecting rates to remain on hold. The main reason given for this unfounded optimism was the fact that the Bank hadn't given the market any advance notice it was planning to hike rates.

But as the pundits discovered to their cost, it's not the Bank's job to let the markets down gently. Its job is to keep the consumer price inflation (CPI) measure within 1% above or below its central target of 2%.And if markets had been paying attention they'd have noticed that inflation is currently running well above that central target. CPI came in at 2.5% in July. The last time it was that high was in September 2005.

Interest rate rise: things can only get worse

And there's plenty of reason to believe that things could get worse in the coming months.

The amount of money flooding into the UK economy is at its highest since November 1990. Money supply growth came in at an annual rate of 13.7% in June.

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.

Gas, fuel and electricity prices are continuing to surge. These 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.

And the Bank's main worry will be that if these price rises start to appear in the shops, 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.

Interest rate rise: businesses angry

Even so, business lobbyists and estate agents were beside themselves with indignation.

This of course is because they are the prime beneficiaries of freely available cheap credit. If borrowing becomes more difficult, people will be able to spend less on buying houses. If house prices start to fall, consumers will feel less wealthy and may even decide they should start saving money again. That's bad news for retailers - in the short term at least.

David Kern of the British Chambers of Commerce said: "We appreciate that it [the Monetary Policy Committee] must make difficult choices but the correct decision would have been to keep rates on hold."

Interest rate rise: did the Bank make a mistake?

But the truth is, if the Bank made any mistakes at all, it was to cut rates from 4.75% to 4.5% in August last year.

By relaxing monetary policy at a time when house prices looked close to flat-lining, the Bank reinforced the fatuous idea held by a surprisingly large number of people that property prices will never fall because 'the government won't allow it.'

Lenders became even more willing to lend indiscriminately to amateur buy-to-let investors and desperate first-time buyers. People were also encouraged to borrow more money against their homes. Mortgage equity withdrawal, which had been on a downward trend, rebounded sharply in the first quarter of this year.

Despite a slump in the rate of borrowing on credit cards and personal loans, total consumer credit has continued to soar this year, reaching a record of nearly £1.3 trillion last month.

Interest rate rise: waiting too long

By allowing monetary policy to remain too slack for too long, the Bank has increased the danger that it will need to take more drastic action - causing more people more pain - in order to push consumers to tighten their belts and start taking control of their mounting debts. That may well have been the thinking, in part, behind the Bank's surprise' decision this month.

Both consumers and businesses need to be reminded that the world is a risky place. The unexpected is always just around the corner. With debts at current levels, consumers are acting as though nothing bad will ever happen again. House prices will always rise, inflation will always be low, and borrowing money will always be cheap.

The Bank's latest move may go some way to persuading people that this isn't the case. The trouble is, the warning will come far too late for the most over-exposed consumers. And with much of that £1.3 trillion debt secured against housing stock, it's very likely that we will continue to see both bankruptcies and repossession statistics continue to soar in the coming year.

First published on MSN Money (04/08/06)

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.