Why interest rates could rise soon.



It’s been a week of ups and downs for the British economy.The inflation rate zooming up to 2.9% on Tuesday was a nasty shock. Unemployment falling to 7.8% from 7.9% yesterday was a pleasant surprise (though as Merryn Somerset Webb points out on our blogs page: What’s good about the employment data?, you shouldn’t take this at face value).

Taken together, these two data points have got many people believing that Britain’s now out of recession.

We’re not so sure. But whether or not the UK economy is – sort of – getting back on track, another risk is growing. Interest – and loan – rates could start rising again sooner than expected.

So what does that mean for you?

Everyone knew that the annual rate of growth in the UK consumer price index (CPI) would rise above the Bank of England’s 2% ‘target’. Bank boss Mervyn King has been warning about it for ages. And the experts were, on average, going for annual inflation of around 2.6%.

But 2.9% was very much top of the range. If the headline CPI goes over 3%, Mr King has to write to the Chancellor to explain why. And there’s a very good chance some Bank stationery will soon be pressed into service. Just this week, the governor said inflation “would be likely to rise over 3% for a while”.

However, there’s no need to worry. Mr King also reckons this should be temporary. Inflation “should return to target in the medium term”. That’s when the nasty effects of energy price hikes and VAT returning to 17.5% are supposed to drop out of the calculations.

So that’s all right then.

Or maybe it’s not – on several counts.

The Bank’s forecasting track record is not good
First, the Bank’s forecasting track record isn’t great. As Edmund Conway points out in The Telegraph, it’s generally behind the curve. “Even when you strip away those volatile bits and pieces and look at core inflation, prices are rising faster than anyone expected. According to the Bank’s forecasts in early-2009, core inflation ought by now to have dropped beneath 1%. It’s now up to 2.8%”.

Second, a lot of the inflation damage has been caused by the weak pound. Sterling has undergone its biggest depreciation since Britain left the gold standard in the 1930s. That may have lessened the damage done by the global recession as UK goods have become cheaper to buyers outside the country. But the other major effect is to inflate the price of imported goods.

The fallout takes time to filter through, but now it’s working its way into shop prices. Sure, the pound is recovering against the euro right now. But that’s mainly because the currency markets are getting spooked about eurozone problems, such as a possible debt default by Greece. It’s not because Britain has become a great place to invest once more.

Also, if we’re right that the US dollar is about to rally: (Two British stocks to buy as the dollar rebounds), the pound is likely to fall against it. So the cost of imported raw materials priced in dollars, such as oil, could keep rising too.

And don’t forget that the Bank has printed almost £200bn of extra pounds over the last year in its ‘quantitative easing’ programme. That’s an awful lot of additional sterling supply. It could eventually depress the value of our currency once more.

Third, the country’s dole queues have shrunk. Not a lot, but job losses were expected to continue for many months after the recession ended. If unemployment has already peaked, the economy might be turning up again. And fewer people out of work would mean more disposable income becoming available to pay higher prices. Also, some reckon Britain isn’t merely out of recession. Goldman Sachs sees the UK growing faster than both the US and Europe next year.

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