Thursday, August 05, 2004

Interest rates are up again today, to 4.75%. This is the fifth hike in the last 8 months, and suggests continuing concern in the Bank of England about inflationary tendencies in the UK economy.

The latest figure (for quarter 2, 2004) for the annual rate of growth of real GDP is 3.7% (up from 3.4% in the first quarter). As a measure of unemployment, the claimant count is still falling, and has been below 900000 throughout 2004. These are both signs of a buoyant economy.

The continuing rise in house prices, and concerns raised by the high price of oil, have generated some concern about inflation. But the former should be self-correcting and the latter should be a one-shot event.

The annualised rate of growth of the consumer price index rose during the second quarter of the year - from 1.1% in March to 1.6% in June. This remains low in relation to the target level, and in this respect it is surprising to witness the sustained hikes in interest rates; it seems to be a severe policy response.

There is, however, reason underpinning the Bank's policy reaction. Over the year to June 2004, lending to individuals increased by some 15%. Much of this is due to house purchases, but growth in consumer credit has also been dramatic, at around 12%. These figures suggest that, unless credit is reined back by rising interest rates, aggregate demand will outstrip supply and inflation will set in. The Bank's decisions on interest rates may therefore be seen as a response to a useful leading indicator of economic activity; rather than responding to what inflation is now, the Monetary Policy Committee is responding to where inflation might be in a few months time.

As things stand, this carries a danger. We might reasonably expect the housing market to self-correct, and we might also expect this to involve quite a substantial fall in the price of a typical house. If this happens while interest rates are still being hiked, consumers will face a double-whammy - house price collapse and high interest rates. Certainly the economy may need to be slowed down in the months ahead. But the housing market may ensure that it does some of the slowing down of its own accord - interest rates are not the only thing that can brake the economy. The MPC needs to toe a very thin line between doing too little and too much. The signs are that it has done enough for the time being.