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Interest rates will rise, but not just yet

The nine members of the Bank of England’s (BoE’s) interest-rate-setting committee voted by six to three in favour of maintaining UK rates at an all-time low of 0.5% at their May meeting. This decision caused no great surprise, given the current environment of muted economic growth and high inflation. The rate of inflation reached 4.5% during April and the BoE believes it could rise as high as 5% during 2011. 

The Monetary Policy Committee (MPC) continues to grapple with the same unappealing choice: either to increase the cost of borrowing in order to curb inflationary pressures, or to maintain interest rates at their current exceptionally low levels in order to support economic growth. The minutes of the MPC’s May meeting revealed a “wider-than-usual” range of views about the outlook for economic growth. They also highlighted “substantial uncertainties” over the effect of the squeeze on real household incomes, the extent to which exports will support growth and whether high profits within the corporate sector would be reinvested or distributed.

This was the fourth consecutive month that three members of the Committee have voted for an increase in interest rates. MPC member Andrew Sentance – the member who has pressed most vigorously for a rate increase – is leaving the Committee and will be replaced by Ben Broadbent, formerly of Goldman Sachs. In a speech delivered during April, Mr Sentance warned that the MPC might have undermined its own credibility by not adjusting its interest-rate policy settings early enough.

The question now is not whether the MPC will increase interest rates, but when. The Confederation of British Industry believes that the BoE will raise rates later this year, while the influential Ernst & Young ITEM Club expects the MPC will “hold fire” until at least November. The latter believes inflation will continue to increase, but does not expect wages to rise significantly, as there is still spare capacity in the labour market. Meanwhile, the British Chambers of Commerce (BCC) has highlighted the international factors – commodity prices and high import prices – that are fuelling UK inflation. The BCC believes that “premature” interest rate rises could have a severely negative effect on jobs and economic growth, and urged the MPC to maintain low rates over the next few months to avoid derailing the fragile economic recovery.

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