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Talk of a UK interest rate hike is premature

The OECD last week urged the Bank of England to raise UK interest rates to 3.5% by the end of 2011 in order to stave off mounting inflationary pressures. Rises should start no later than the fourth quarter of this year, argues the organisation, in the belief the consequences of not undertaking such measures could be dire – weak growth, high unemployment, fiscal deficits and significant economic imbalances for years to come.

Yet, any immediate rise in interest rates has been dismissed by many economists as suicidal for the economic recovery, particularly coming on the back of planned spending cuts by the new coalition Government. It would certainly be a significant shock for markets. The yield curve suggests interest rates will still be below 1% in two years time – and not rise to 3.5% for another 10 years. City forecasts are higher, suggesting interest rates may be at around 2% by the end of 2011. However, both are a long way short of the OECD’s target.

The OECD admits that if taxes rise and public spending is cut, the need to increase rates may diminish. This is certainly in prospect. The new Government has already announced £6.2bn worth of savings with further rises likely to be announced in the Budget of 22 June.

Equally, there are some who have questioned the OECD’s analysis. At 3.7%, inflation is certainly well above target. However, the Bank of England’s central forecast is inflation will start to drop in the middle of this year, falling well below the 2% target and remaining there for several years, even with no change in monetary policy. Mervyn King, the bank’s governor, has suggested rates are likely to remain low for longer than markets currently expect.

Some economists may be suggesting greater volatility in inflation but high, prolonged inflation is still a niche view. It is also clear there are some mitigating factors. The weakness of sterling has raised the cost of some imports that make up the basket of goods on which inflation is measured. Equally, the withdrawal of the cut in VAT has created a blip in the comparative statistics.

Certainly, things must return to ‘normal’ at some point. People need to have less money, either through tax rises or higher interest rates or both. The problem is ensuring the stimulus is withdrawn in a controlled way with minimum disruption to recovery. The OECD way is likely to prove a little too hair-shirted for the politicians.

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