Evanomics

On interest rates...

• Evan Davis | Notes on Real Life |
• 9 May 07, 04:44 PM

The Monetary Policy Committee of the Bank of England has started its monthly meeting to set interest rates. Back in the middle of February, I confidently predicted that rates would rise when the outcome of the meeting is announced tomorrow.

As inflation has risen since I made that prediction, I have no reason to dissent from the unanimous view of the professional pundits that there will indeed be a quarter point rise.

I would put about a ninety per cent chance on that outcome, with a five per cent chance of a half point rise, and a five per cent chance of no change.

As it happens, MPC members will have seen a preview of next week's inflation release. But unless there is an enormous shock contained therein, the committee should not be much affected by those figures, as it takes a medium term view and tries not to react to every twist in the data.

Now my sense at the moment is that interest rate rises are beginning to hurt a portion of the population quite significantly. While any one rise can be dismissed as having only a modest effect (maybe £20 a month for each hundred thousand pounds of mortgage), four rises can add £80 to the monthly payments and, well, then you are talking about serious money.

Obviously, it's just normal everyday economic life for inflation to go up, for interest rates to follow and for mortgage borrowers to squeal. I could end my blog here, and say there's nothing more to say about where the economy is.

But the position the economy finds itself in at the moment feels more significant than normal.

The problem at the moment is that the economy is arguably in the midst of a mini-boom and incipient inflationary pressure may be worse than it looks. Obviously, the frothy state of the housing market is the most worrying sign.

If one believes that the boom in asset prices generally is a telling indication of overheating, then one might suppose the Bank will have more work to do than one last quarter point rate rise.

And it's easy to imagine that the effect of yet more rate rises could be yet more painful. Instead of mortgage borrowers just finding their monthly payments going up, they might find an economic slump causing their monthly income to go down. And that's when the trouble starts.

Of course, it might be that houses are not over-priced and reflect genuine supply shortage (though it becomes harder and harder to believe that). And it might be that if they are overpriced and soon crash, the economy generally will nevertheless survive unscathed.

But one should entertain the possibility that other, less benign scenarios could occur. At least, this latest decision does seem to come at an interesting juncture.

As it happens, the man who warned about all of this is Mervyn King, who gave an interview to The Times on the day he became governor of the Bank of England almost four years ago.

He told us, "there are plenty of things that could throw up awkward challenges..." And he said, "there will be bigger movements in inflation away from the target... ". He has been right on both prophecies.

He could predict that things might get rough, because the economy has been in a vulnerable position, enjoying strong growth, built on strong consumer spending, fuelled by cheap imported goods and sustained by low interest rates.

It has always been the case that if the ever cheaper goods that have been crucial to holding this formula together stop falling in price, some kind of painful adjustment becomes necessary.

And that might be where we are now.

There was one other thing the governor said in his Times interview four years ago - "The feelgood factor won't be there in the same way...". With interest rates likely to hit five and half per cent tomorrow, mortgage holders probably feel that was his most accurate prophecy of all.

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