Interest rate rise considerations

The Monetary Policy Committee (MPC) sets the bas interest rate for the Bank of England each month. In July the MPC voted 6-3 in favour of a rate rise from 5.5% to 5.75%. However, it appears from the minutes of the July meeting that not all members of the MPC are in agreement about the best way to tackle inflation.

The MPC sets a rate it judges will enable the target for inflation to be met. There are nine members of the MPC: the Governor, the two Deputy Governors, the Bank’s Chief Economist, the Executive Director for Markets and four external members who are appointed directly by the Chancellor of the Exchequer. The last four appointees have the objective of ensuring that the MPC gains expertise and thoughts from outside of the Bank to help it make its decisions.

Members do not represent groups or political parties and are independent. Each member has a single vote on interest rates – one member, one vote. The decision on interest rates is based solely on the result of that vote. A representative from the Treasury is also present at the meetings; this representative has not vote, but does take part in discussions on policy. The representative will take Government policy thinking to the meeting, and keep the Chancellor informed of monetary policy.

MPC meetings are held monthly to set the interest rate, backed up by a continual feed of information from Bank staff throughout the month, including a pre-MPC meeting on the Friday before the main MPC meeting. The nine members are kept up to date with all the latest relevant economic data and trends in the UK. Agents for the Bank talk directly to business leaders to understand current and future economic prospects.

At the July meeting it seems that a major split occurred with policymakers uncertain as to the best way to control inflation.

Most major experts now expect at least one more quarter point rise this year to take the rate to 6% which would be its highest level since February 2001. This week’s inflation figure was down to 2.4%, but that might not be enough of a fall to save another rate rise – even as soon as August. The rising interest rate has helped to buoy the pound against a weak dollar, and currency traders saw the inflation announcement as more good news for the pound so they must believe interest rates are still on the rise.

The July rise represented a triumph for the Governor Mervyn King. He had wanted an increase in June, but was defeated 5-4 in the vote. Those who vote for a rise are known as hawks, and those who vote against are known as doves. Paul Tucker and Kate Barker joined the hawks in July to vote with King, Sir John Gieve, Tim Besley and Andrew Sentence. This time the doves were Deputy Governor Rachel Lomax, Charles Bean and arch-dove David Blanchflower. Commentators on the MPC now see as many as four camps within the group, including the hawk-dove split and camps within camps. The quarterly inflation report due out soon will be crucial to the way the MPC votes in August.

There have, however, been some developments recently that may help the chances of avoiding a rise in the base rate.

The first is the obvious split in the MPC, with last month’s three doves unlikely to cross to side with the hawks, and those that changed to the hawks last month possibly thinking that that rise will do for now.

Another reason is that the pressure on wages is still not high, which gives evidence to the labour market being slack currently. Headline average earnings growth fell back to its lowest level for 18 months.

The part that mortgage interest adds to the retail price index went up steeply in June, which suggests that the earlier base rate increases are now reaching borrowers.

Calculations indicate that an average outstanding mortgage will take a hit of around 0.4% in the second half of the year, even without further base rate hikes.

Lastly, sterling is now so strong and higher interest rates only push it higher. The trade-weighted exchange rate is now about 4% higher than its average level in 2006.

All these points would support there being no further rate rise. Against this, however, is the high level of the growth of money supply. This may be helped by the cooling mortgage market and a slowdown in credit requests. The strength of the M4 money supply hides a fall in retail deposit growth since early last year, and that leads consumer spending.

The doves and those swaying will point to low earnings growth, the strength of sterling and an expected decrease in headline CPI inflation as their key points. In August, at least, the doves should win the day.