Bank shocks City with surprise interest rate rise

The increase in interest rates announced by the Bank of England yesterday took the financial markets by surprise. And, as Diane Coyle, Economics Editor, discovered, City experts could not agree on how much further the Bank's Monetary Policy Committee would go.

The quarter-point rise in interest rates to 7.25 per cent sent the pound up and the money markets sharply lower yesterday. Many traders had persuaded themselves that the recent stockmarket turbulence would delay the next rate move, and they were therefore caught on the hop by the Monetary Policy Committee's decision.

In the aftermath of the midday announcement the pound jumped by a pfennig to just under DM2.91, while its index climbed by 0.9 to 103.3. The sterling futures market fell sharply, betting on rates being another half point higher by next June.

Many City economists expressed either surprise or disappointment at yesterday's move. "I'm surprised the Bank has chosen to ignore the strength of the pound and the turbulence in financial markets," said Simon Briscoe at Nikko Europe.

The publication of the Bank's Quarterly Inflation Report next week was seen as the likeliest explanation for the timing. Following yesterday's move the report will be able to show inflation meeting its target rather than overshooting it.

However, the experts were sharply divided on how much higher rates will need to be raised to meet the 2.5 per cent target.

Roger Bootle, chief economist at HSBC Markets, predicted at most one more quarter point step in the first quarter of next year. "The markets have overreacted," he said.

On the other hand, Steven Bell, head of research at Deutsche Morgan Grenfell, said: "The MPC must have it in mind to do more. The labour market indicators are all flashing red." He said rates could climb to 8 per cent next year.

The Bank's statement indicated that skill shortages in the jobs market and unsustainable growth in GDP had tipped the balance. It admitted growth would slow next year but said the balance of risks was such that the Committee had judged a modest rate rise necessary.

Behind the uncertainty about future rate rises lie diverging assessments of the current strength of the economy. Two leading forecasting groups joined business organisations yesterday in saying that the Bank's move was unnecessary.

In its latest report the London Business School's Centre for Economic Forecasting said the economy is heading for a "soft landing". But Andrew Sentance, its director, said that although the risk of recession was still ``remote'', the Bank had made a slowdown in 1998 more likely.

"The Bank of England has chosen to take out an insurance policy against potential inflation risks in the pipeline," he said.

The new forecast forsees inflation hitting a peak of 3 per cent in 1999, well within the Government's 1.5 per cent to 3.5 per cent target range, without any further rate rises.

Separately, Garry Young of the National Institute of Economic and Social Research agreed that policy was already tight enough for the inflation target to be met. The rise "increases the chance of a recession next year", he warned.

This warning was echoed by some business groups. Ian Peters, deputy director general of the British Chambers of Commerce, said: "In our view recent surveys do not provide sufficient evidence for a further rise at this time."

"With UK interest rates the highest of G7 countries, this will further constrain Britain's international competitiveness," he added.

However, mortgage lenders reacted calmly, with most announcing that they would not make any decisions about mortgage rates immediately. The two biggest mutual lenders, the Nationwide and Bradford & Bingley, made a widespread move unlikely by saying they would hold their rates until the end of December and end of January respectively.

Nor did the lenders think the latest rate rise would harm the housing market. "As long as base rates do not go a lot higher, there will be no impact. The housing market recovery is solidly based," said Gary Marsh of the Halifax.

Some economists reckon the pace of growth is still so rapid that the Bank will eventually have to stamp harder on the brakes. Most pointed to the mounting evidence of skill shortages and pay pressures in the jobs market as the biggest concern.

David Walton at Goldman Sachs said one more increase would get the economy back to its trend. "But that is the minimum that is needed to keep inflation on target," he said. The risk was that rates would need to be raised even further.

And Kevin Gardiner of Morgan Stanley said: "The Bank has given its credibility a real boost."

But with even the most pessimistic analysts forsee interest rates rising no higher than 8 per cent, this would be the lowest peak during a business cycle for a generation.