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Last Updated: Thursday, 9 November 2006, 14:23 GMT
Economy drives further rate rises
By Steve Schifferes
Economics reporter, BBC News

The Bank of England has raised interest rates for the second time this year to 5%. But will they continue to go up?

The Bank of England is charged by the government with keeping inflation under control, with a target rate of 2%.

What interest-rate changes mean for you

So it is not surprising that with inflation now hovering around 2.5%, the Bank decided to act.

Interest rates have been rising in many countries around the world as banks try to curb inflationary expectations as economic growth accelerates.

In the UK, economic growth has been running ahead of the Chancellor's forecast for some months, although it recently slowed to a year-on-year rate of 2.6%

Additionally, house prices are continuing to rise strongly in most parts of the country, with prices increasing at an annual rate of more than 8%, according to the latest survey from the Halifax.

The Bank has been concerned that higher house prices encourage people to borrow and spend more, thus boosting inflation.

Uncertainty

In addition, the Bank is worried that higher wages will boost inflation.

Graph of Halifax and Nationwide houses price indices

Wages are rising in the UK by around 4.2% annually, just below the Bank's informal target rate of 4.5%.

So far two things have helped keep wages and prices in check.

Higher immigration from Eastern Europe may have lowered inflationary pressures on wages despite relatively high employment rates.

And cheap prices on imported goods, particularly from China, have kept the lid on High-Street prices despite the strong demand.

Both of these factors may have less significance in the future, if the rate of immigration slows, as the government wants, and if China is forced to revalue its currency and raise the price of its exports.

The Bank believes that, in an uncertain world, it is better to err on the side of caution and raise rates- rather than embed inflation in the system, where it is very hard to get rid of later.

Bank governor Mervyn King has repeatedly warned consumers that the rather benign interest-rate climate may be coming to an end, and the world economy now contains more risks than before.

Effect on growth

Some economists believe that the current round of rate rises will significantly slow the UK economy next year.

Oxford Economic Forecasting (OEF) says that growth will slow to 2.3% next year, based on anticipated weaker demand for exports and more reluctance to spend in the shops.

However, Alan Castle, UK economist with Lehman Brothers, expects that higher growth from eurozone exports will compensate for an expected slowdown in the US, and lead the Bank to make at least one more interest rate increase early in the New Year.

With the US economy appearing to be slowing down sharply (annualised growth in the most recent quarter was only 1.6%) the Bank may also want to wait until a clearer picture of the international economic climate emerges.

Budget worries

In the next few weeks, Gordon Brown is due to present his pre-Budget report and is expected to revise upwards the government's official growth forecast.

However, his decisions on future government spending - and borrowing - will also affect the Bank's thinking.

So far, the government is running a large, and larger-than-planned, budget deficit of nearly 3.4% of gross domestic product, and the extra state spending has helped stimulate growth but also added to inflationary pressures.

Mr Brown is planning a sharp slowdown in the growth of public spending from 2007 - which could help moderate economic growth.

The Bank's interest rate hikes increase the size of the deficit, by raising the cost of public borrowing.

But they could also lead to cutbacks in consumer spending from people who have over-borrowed, which would in turn slow economic growth.

With so many uncertainties, it is likely that the Bank will again wait a few months before making another rate decision.

But there is little doubt of the direction of change if they decide to move.


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