Mixed messages on interest rates
Tuesday, 17 January 2006 12:00
Official figures on inflation and comments from Bank of England governor Mervyn King have provided a mixed message on interest rates today.
The Bank's interest rate setting Monetary Policy Committee, chaired by Mr King, sets the base rate of borrowing in the UK in an attempt to keep inflation in the UK as close to two per cent as possible.
As such, news that inflation fell in December to two per cent - with core inflation at a ten-month low of 1.3 per cent - saw analysts predict that interest rate cuts could be on the cards.
"Today's news [on inflation] supports those in the market who expect a rate cut later in the year," said Laura Phaff, economist at the cebr think tank.
Howard Archer, economist at the Global Insight consultancy, went further.
"This very much keeps the door open for an interest rate cut in February, although the Bank of England may still prefer to wait while it monitors the strength of consumer spending and wage settlement levels early in 2006."
But while official data pointed towards an interest rate cut, comments from Mr King hinted at base rate rises.
Speaking at a dinner for Kent business contacts last night, he said that changes in the global economy could send interest rates higher in the future.
He points out economic growth and internal integration in places like India and China have led to fundamental changes in the world economy.
One of the results of this is that 'real' interest rates (interest rates minus inflation) are at historic lows of around one per cent.
But as these developing economies move forward, a change in their economic policy could alter this picture.
"It is not at all clear that rates will persist at such low levels," Mr King said.
He pointed out that increased domestic demand in China and elsewhere in Asia, along with a pick-up in business demand in the West, could radically alter the current situation.
"Where that would leave sterling and the outlook for inflation [and so interest rates] in the UK is impossible to know in advance," Mr King said.
However, he added: "It is quite possible that real interest rates could remain low for some time."
Overall, the mixed messages on inflation mean that the market is waiting until January 25th and the publication of the MPC's latest minutes with a heightened sense of anticipation than has been the case recently.
If more than one member of the MPC voted for an interest rate cut in January, or there was extensive discussion of one, the expectations of a fall in base rate in the next two months will heavily increase.
If not, it is likely that rates will stay on hold - potentially for the rest of the year.
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