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They also urged the Fed to keep tightening next week...

A surprise increase

Aug 3rd 2006

From The Economist print edition

But only the timing was unexpected

THE Bank of England caught financial markets on the hop this week by raising the base rate to 4.75%. Only a handful of City economists had predicted the quarter-point rise made on August 3rd. The increase reclaimed the cut made a year ago when the bank lowered the rate to 4.5%.

The decision may have been unexpected, but the case for an immediate rise in interest rates was formidable. Since the bank's monetary-policy committee met in July, when it voted unanimously to keep the base rate at 4.5%, inflationary pressures have intensified.

As recently as March, annual consumer-price inflation was 1.8%, below the government's target for the bank of 2.0%. By May it had risen to 2.2% and in June it jumped to 2.5% (see chart). Since the consumer-price index series began in 1997, it has only been this high on one previous occasion (last September).

Worryingly, inflation could well move even higher in coming months as the recent heatwave pushes up food prices and domestic energy costs rise yet again. British Gas, for example, has announced that it will start charging 9.4% more for electricity and 12.4% for gas early in September. George Buckley, an economist at Deutsche Bank, expects that such increases in households' energy bills will add to consumer-price inflation in the third quarter of 2006.

Not only has inflation picked up, but the recovery from last year's economic slowdown has also gathered momentum. The economy has now grown faster than its historic rate of 0.6% a quarter for nine months. GDP growth averaged 0.7% in the final quarter of 2005 and the first three months of 2006; and it picked up to 0.8% in the second quarter.

As a result, any margin of spare capacity that opened up in the preceding slowdown is being eroded. Furthermore the prospects for GDP growth look quite bright. In overseas markets, America may be slowing but the world economy and global trade are still growing strongly. In particular, the euro area, which purchases half of Britain's exports, is at last showing some vigour.

At home, too, there are signs that consumers are perking up. Retail sales rose by 2.1% in the second quarter of 2006, making this the most buoyant period for retailers for more than two years. Although special purchases connected with the football World Cup may have lifted spending temporarily, consumption is also likely to be boosted by the continuing resilience of the housing market. Mortgage approvals for house purchase were a higher-than-expected 120,000 in June, well above the average monthly level of 107,000 since the start of 2000. And the annual rate of house-price inflation accelerated from 5.0% in June to 5.9% in July, according to the Nationwide building society.

Another worry about the outlook for inflation is that the money supply has been growing so rapidly. Broad money (M4) rose by 13.5% in the year to June. This was the fastest growth for almost 16 years, and well above the rate of around 9% that the bank recently estimated to be sustainable over the long run.

There were some arguments for the bank to stay its hand. Sterling has recently been strong, which will help to abate inflationary pressures. More important, there is little evidence that these pressures are feeding through to the labour market. Indeed earnings growth continues to be remarkably restrained, in part because of the impact of higher immigration. Wages, excluding bonuses, are rising at an annual rate of 3.8%, according to the latest figures.

The bank's rate-setters decided to err on the side of caution, however. By moving early, they are sending a clear signal that inflation will be kept at bay. That will help to prevent a destabilising rise in inflationary expectations.

The bank is almost certainly not done with its monetary tightening. But the timetable for another rate rise is unclear. More light will be cast on this when the bank publishes its quarterly Inflation Report on August 9th. The City will scrutinise this even more closely than usual for clues about if and when rates will rise again.

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  • 301 Brexit, House prices and Summer 2020

    1. 1. Including the effects Brexit, where do you think average UK house prices will be relative to now in June 2020?

      • down 5% +
      • down 2.5%
      • Even
      • up 2.5%
      • up 5%

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