Prospect for UK Interest Rates in 2007

On January 17th 2006 the MPC raised interest rates to 5.25%. The decision to raise interest rates, was seemingly justified a couple of days later, when inflation rose to an 11 year high of CPI 3%. This is on the edge of the governments inflation target of 2% +/-1. Although inflation is low by historical standards the MPC will be keen to move inflation back to its inflation target and maintain the strong credibility of monetary policy. Thus with inflation currently above its target the likelihood of interest rates rising is quite strong. Higher interest rates will dampen demand and hopefully keep inflation in check.

Therefore changes to interest rates will depend a lot on inflationary trends. There are several factors to suggest that inflation could continue to be a problem.

  1. Higher energy prices are likely to be an issue. Continued rising demand from India and China is putting pressure on commodities causing prices to rise. In particular this means the lower manufacturing prices we have been enjoying from China will become less significant. Inflation is also starting to creep up in other industrialised countries, although not as much as UK.
  2. UK housing prices have continued to rise at a rate above inflation.(9%) in 2006. The MPC isn’t directly influenced by house prices, but rising house prices tend to feed through into higher inflation because people have more wealth and confidence to spend.
  3. The minor increases in interest rates may not be enough to reduce spending in the economy. It is true they will impact on those with very high mortgage payments, but there is a significant sector of the economy which are not effected by interest rates very much (e.g. people who have paid off most of their mortgage). Therefore interest rates may have to rise by more than expected to reduce inflation.

 

Having said that some economist argue interest rates are close to peaking.

  1. Firstly rises in interest rates often have a time lag delay effect. Therefore the recent rises from 4.5% to 5.25% may start to have more of an effect on consumer spending and confidence in the coming year.
  2. House prices may be close to peaking. House prices have persistently defied many people’s predictions and continue to rise above the rate of inflation. However there is evidence of buy to let buyers starting to cash in on their profits. Many first time buyers are increasingly priced out of the market. If house prices did stop rising or even started to fall this would have a very significant impact on reducing spending making further interest rate rises much less likely.

Although inflation is close to 3% much of this latest rise can be attributed to one off factors such as rising excise duties and rising energy prices. If these factors are stripped out then CPI inflation is close to its target. However having said that if we look at the old measure RPI then inflation is much higher 4.4%. This figure includes housing costs and is considered by some economists to be a more accurate reflection of what is happening in the economy.