How far will interest rates have to rise?

By Steve Schifferes BBC News Online economics reporter

House price inflation is worrying the Bank of England

The likelihood of further rises in UK interest rates is now beginning to alarm borrowers. But how high could they go?

After Thursday's rate increase by the Bank of England, financial markets are predicting that UK base rates could reach 5% by the end of 2004.

And interest rates are beginning to rise in other countries as well, with Australia putting up its interest rates to 5% on Wednesday.

The UK rate increase looks like the beginning of a general upward move in rates worldwide, based on a recovery in the world economy.

That recovery is being driven by the US economy, which grew at an annual rate of 7.4% in the last three months.

Japan's economy is also on the mend, and even the slow-growing eurozone is showing some signs of recovery.

All these factors could boost UK exports, and the UK economy overall expanded by a stronger-than-expected 0.6% in the last two quarters.

While the strength of the world recovery is still uncertain, it looks much stronger than a few months ago, when dire predictions of a third year of economic slowdown were widespread.

Inflation target

The Bank of England's mandate is to keep inflation under control over the next two years, and it will publish its new forecasts for inflation one week after it makes its rate decision.

Mervyn King: Economy will be 'more volatile'

Inflation as measured by the government's inflation index RPI-X, which takes out mortgage repayments, has been running slightly above the 2.5% target for several months, and stronger economic growth is expected to accelerate that trend.

More importantly, the Bank of England has been alarmed by the growing volume of consumer debt and mortgage liability, which has now reached 120% of total household income.

But the Bank has traditionally been cautious about taking asset prices like housing into account when raising interest rates.

Bank's MPC member Steve Nickell has pointed out that it cannot be sure how homeowners will react to a sharp rise in interest rates, and does not want to provoke a housing market crash that could put any economic recovery into reverse.

Mervyn King, the new governor of the Bank of England, has already stated that he expects the economy to be more "volatile" than it has been in recent years.

"When shocks, as they will, hit our economy, it is almost inevitable that there will be somewhat greater volatility of both output and inflation than the remarkable stability to which we have become used in recent years," he said.

New inflation measure

The Bank may have been tempted to act now, before the government forces the Bank to use a new inflation measure which will show price increases to be below, rather than above target.

In June the Chancellor announced that he will be changing the BoE's inflation target to a new measure known as HICP (harmonized index of consumer prices) to move into line with EU practice.

The new measure usually reports a lower rate of inflation than the current one, RPIX, and the government is widely expected to set a new target at 2% in the pre-budget report in December.

But, with HICP inflation currently running at about 1.5%, this may mean that the UK falls consistently below its new inflation target for some time to come.

Cautious Bank

The imminent change in its inflation target may cause the Bank to be more cautious than usual in changing interest rates in the next few months until the public is familiar with the new inflation measure.

The Bank cannot be sure how homeowners will react to a sharp rise in interest rates, and does not want to provoke a housing market crash

But it also has another reason to be cautious - since the underlying figures for the growth of the economy have also been substantially revised.

These statistical revisions by the Office for National Statistics mean that the Bank is not sure how fast the UK economy is actually growing.

Although most economists believe it is still expanding at below its economic potential, it appears to growing faster than previously thought.

And the Bank is not sure how homeowners will react to any interest rate rise.

So it may prefer to wait for further signs of a housing market slowdown before acting further.

These factors could affect the timing of any additional rate increases, which may be put off until the second half of 2004.

All this makes the next few months extremely interesting for MPC watchers - and more difficult to predict than usual.