Eyes on the MPC as speculation on interest rates grows

To raise or not to raise? That is the main question on the lips of most commentators and economists after last week’s announcement that consumer prices index (CPI) inflation in Britain in December surged to an eight-month high of 3.7%, up from 3.3% in November.

The consensus estimate had been that CPI inflation would rise to 3.4%.

As a result, inflation continues to be above target. Many expect this will be the case for the rest of 2011, prompting several letters from Mervyn King, the governor of the Bank of England, to George Osborne, the chancellor.

According to Morgan Stanley, inflation could rise further in January, reflecting the effects of increased air fares, higher energy costs and food price rises, which the investment bank says were much stronger in December than it had forecast.

Lombard Street Research, an economic consultancy, says CPI inflation could easily hit 4% this year, with the annual rate staying above the Bank of England’s 2% target owing to the rise in VAT. However, Jamie Dannhauser, an economist at Lombard, says that once VAT falls out of the annual calculation Lombard would expect inflation to drop below the 2% target.

According to Mike Riddell, a fixed income manager at M&G, the bond market is pricing in three quarter-point rate rises by the end of the year, the first of which he says has been fully priced in for June. (article continues below)

Morgan Stanley, meanwhile, does not expect a rate increase until August but expects rates to end 2011 at 1% and hit 2% at the end of 2012.

Simon Ward, the chief economist at Henderson Global Investors, says the jump in inflation results from the loose policy of the Bank’s Monetary Policy Committee (MPC).

While he considers the MPC was right to cut rates back to 0.5% in March 2009 and start the first round of quantitative easing, he says that by this stage last year it was clear the economy was recovering and inflation had not fallen in the way the MPC had expected.

“At that point they should have started withdrawing the emergency stimulus by raising interest rates in the first instance,” says Ward. “If they had, sterling would now be stronger, ­helping to cap imported inflationary pressures.

“An early rate hike would also have demonstrated their commitment to the inflation target, thereby firing a shot across the bows of retailers and firms planning price increases.”

So what is the MPC to do now? Andrew Sentance, a member of the committee, has for months been voting for a quarter point increase in rates, taking them to 0.75%. His rationale is that several consecutive quarters of “robust” British GDP growth streng­then the case for altering policy “sooner rather than later”.

Ward says the minutes of the latest MPC meeting, to be published this week, will show whether Sentance received more member support for a rate rise at the last meeting, which left the rate unchanged at 0.5%.

“If he did get more support, we expect rates to rise, possibly as soon as March,” says Ward. “Either rates will rise soon or they won’t at all. If they are going to do it, why wait? If, however, the minutes don’t show added support for Sentance, I will change my view on a March rate rise.”

Those who do not want to see a rate rise argue that it would be a direct threat to future GDP growth. Jim Leaviss, the head of retail fixed income at M&G, says raising rates would be akin to “GDP suicide” and bring deflation risks back into play.

The main worry of a rate rise is the effect it will have on British consumers, who are already feeling the pinch from the VAT rise to 20% in addition to higher living costs created by fuel and food price rises.

Neil Dwane, the chief investment officer for Europe at Allianz RCM, does not expect the Bank to raise interest rates in 2011. The reason it will not, he says, is that it knows many British households are sensitive to the cost of their mortgage.

“Statistics show that two-thirds of UK households with a mortgage are now on a floating rate policy, so any rise in interest rates will hurt the UK consumer instantly,” he says.

Ward argues that while a rate rise would reduce borrowers’ discretionary income, this would be offset by the boost to savers, meaning it is not obvious that consumers’ spending power will be massively hit.

Dwane, however, says the central bank has to beware of being overly aggressive with interest rates because of the natural headwinds to the economy in the form of the rise in VAT and the government’s austerity plans.

“In our view [the Bank] has to ­tolerate the higher level of inflation, which we think will exceed its mandate for the whole of 2011, because its priority is to keep growth going while we have the austerity plan over the next three years.”