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Last Updated: Thursday, 6 May, 2004, 11:04 GMT 12:04 UK
Where are interest rates going?
By Steve Schifferes
BBC News Online economics correspondent

The Bank of England has raised interest rates for the third time since November. But what is the outlook for interest rates over the rest of the year?

The Bank of England's task, as defined by the government, is to meet the inflation target of 2%.

The government defines that as a "symmetrical target", and asks the Bank governor to explain when inflation is one percentage point above or below that target.

The current measure of inflation - the consumer price index - stands at 1.1%, and few economists expect it to climb above 2% by the end of the year.

Nevertheless, the Bank has raised interest rates from 3.5% to 4.25% so far - and financial markets expect rates to go up further, to about 5% by the end of the year.

And in America, despite low inflation and a jobless recovery, the Federal Reserve has indicated it will be gradually raising interest rates from their 43-year low of 1%.

So what is worrying the Bank?

Housing the key

In a word - housing.

The UK housing market is peculiarly vulnerable to boom-and-bust cycles, as the Miles and Barker reports produced for the Treasury have indicated.

A guide to the ups and downs of the UK economy

So far, rate rises have failed to cool the property boom, which is fuelled by a shortage of affordable homes and fears by first-time buyers that they have left it too late to get onto the housing ladder.

The Bank is particularly worried by what is called "equity release", where people use the increased value of their home to increase their mortgage in order to borrow more money to spend on cars or holidays.

This is what happened in the late 1980s, and led to an unsustainable consumer boom which ended in a housing crash.

Although compared with the 1980s people are paying out less for their mortgage because interest rates are low, their overall debt levels are at record highs.

The Bank is worried that higher and higher consumer spending is inflationary, and eventually it would have to step in and steeply raise rates if things threatened to get out of hand.

That would be worse than a slow squeeze on mortgages, through higher interest rates, that led to a gradual cooling of the over-heated housing market.

Asset price bubbles

Last year, Bank governor Mervyn King warned that "changes in asset prices (could) lead to an imbalance in the economy that poses the risk of the large demand shock".

But he also pointed out that it was difficult to know when such asset bubbles would burst, and furthermore it was difficult to know just how to control them.

Nevertheless, increasing attention is being focused on the housing market.

Some members of the Monetary Policy Committee (MPC) - and occasionally the Bank governor - seem to be arguing that this issue would loom even larger in their deliberations if they considered the course of inflation over a longer time period than two years.

But others believe that it is too difficult and uncertain to target asset prices, as so many different factors other than interest rates seem to affect them.

And they point out that the Federal Reserve explicitly refused to target either the stock market "bubble" of the 1990s or the current US house price boom - with no ill effects so far.

Output gap

What is also worrying the Bank is that the economy is already growing too fast, above its sustainable level for non-inflationary growth.

The Bank believes that it should "take its foot off the accelerator" by moving interest rates to what it believes would be a neutral level of around 5% - especially as the Chancellor has also tried to accelerate growth by running a huge budget deficit.

But the Treasury questions this scenario, and claims that because of slower growth in previous years there is still an "output gap" between potential and actual economic output, and therefore some slack for the next two years.

Most independent observers back the Bank's view of the macro-economic situation - and also believe that in the future, the overall tax take will have to go up to help cool the economy.

Manufacturing revival?

Both the Bank and the Treasury are hoping that the momentum for the economic recovery will switch from consumer demand to manufacturing exports, which would ease inflationary pressures.

And, as the world economy revives, there is every chance that this will happen.

But the high pound is making export-led growth more difficult, by making British goods more expensive overseas.

So the Bank has to be careful about raising rates too fast.

That could hurt manufacturing industry in two ways.

First, manufacturers would have to pay more to borrow money.

But in addition, higher interest rates tend to raise the value of the pound on international currency markets by attracting short-term investment.

And the higher pound means that UK manufacturing exports become even more expensive overseas.

Luckily, with the US Fed now poised to raise interest rates, the value of the pound against the dollar is already falling.


So the way is open for more rate rises.

And in some ways, given the importance that the Bank attaches to communicating its intentions clearly to financial markets, it is unlikely to want to surprise their expectations of a rate rise unless there is a very good reason.

But expect the Bank - like the Fed - to move cautiously in its campaign to raise interest rates and cool the housing market.

Central banks are not sure whether they know how to influence asset prices like housing.

And they want to learn the lessons as they go along.

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