Mixed views on what will happen to UK interest rates as they remain at record low

News - Banking

Written by Ray Clancy

Friday, 06 August 2010 10:28

There has been a mixed reaction to the decision by the Bank of England to hold interest rates at their record low level of 0.5% as concerns increase about inflation levels in the UK.

The more important issue will be the releases of its inflation report next week which is expected to show growth slowing and inflation rising in the short term before coming back under control.

This is because the Organisation for Economic Co-operation and Development (OECD) has concluded that UK interest rates will have to rise to 3.5% by the end of 2011 if the Bank of England is to keep a lid on high inflation.

‘Rates would have to start rising this year from the historically low level of 0.5% because inflation expectations were creeping up. The reversal of the December 2008 VAT cut and higher fuel prices have contributed to the recent jump in inflation,’ the OECD said.

‘Notwithstanding the temporary nature of these price developments, the gradual drift up of some measures of inflation expectations implies a need to increase interest rates earlier than previously thought and no later than the last quarter of 2010. The projected increase of core inflation to the Bank of England target warrants policy rate to 3.5pc by the end of 2011,’ it added.

Inflation has overshot its 2% target for 41 of the past 50 months and, at 3.2%, is currently at a level that demands a letter of explanation from the Governor, Mervyn King. However, most policymakers view the factors that have pushed inflation up, such as sterling’s weakness and higher oil prices, as one-offs that will fade away in the face of public spending cuts.

Andrew Sentance is the only member of the nine strong Monetary Policy Committee to have voted for a rate rise at the past two meetings and is expected to have been a solitary voice again yesterday.

Last week the Bank of England governor Mervyn King said that it may be a considerable time before interest rate return to normal.

According to Duncan Higgins, senior analyst at Caxton FX, Sentence is unlikely to get any support from his colleagues. ‘King appears happy to tolerate the comparatively high level of inflation in order to safeguard the recovery. The rhetoric at present is still not pointing to an interest rate rise until mid 2011 at the earliest. This is based on the fact that the possibility of adding further monetary stimulus is still very much on the table,’ he said.

‘In the short term, the Bank can do little about inflation and so policymakers are likely to continue taking a wait-and-see approach whilst the outlook remains so uncertain,’ he added.

Ray Boulger of leading independent mortgage adviser John Charcol expects inflation to remain above the 2% target for most of next year and believes there won’t be a sudden rise in interest rates.

Even more confident that interest rates will remain low is the Ernst and Young’s ITEM club whose latest prediction suggests that the base rate will remain on hold until the end of 2013.

But former Bank of England deputy governor, Sir John Gieve, believes that interest rates will have to rise earlier and more sharply than expected to keep inflation under control.

Speaking recently at the Fathom Financial Consulting’s Monetary Policy Forum, Sir John said he ‘wouldn’t be at all surprised to see interest rates at 2.5% a year from now’.

The European Central Bank also decided to leave rates on hold at 1% as president Jean-Claude Trichet said member economies were in better shape than expected, having survived the Greek sovereign debt crisis earlier this year. ‘We are now in a situation which is obviously better than before,’ he said.