Wednesday, 9 May 2007

Thursday is the big day for interest rates

Will it be a quarter percent increase or will the Bank of Bngland have some backbone and put the base interest rate up a half percent. Judging by the Bank's sorry past performance, it will wimp out and settle for a quarter percent hike.

Looking back on recent interest rate decisions (see above), it isn't hard to see a long line of misjudged rate decisions. The decisions taken between late 2001 and 2003 were just plain daft. The Bank over-reacted post 9-11 and kept on over-reacting right the way through until the middle of 2003. The rate cuts in February 2003 and July 2003 were totally unnecessary and laid the basis for today's housing bubble. The bank quickly realized their mistake and promptly started hiking rates in 2004. As usual, the MPC chickened out and stopped raising rates when they should have kept on going. Furthermore, it kept rates too low throughout late 2004 and early 2005. Neverthless, these rate hikes did go some way to slowing down house price inflation.

Then we have the totally inexplicable rate cut in August 2005. Not only did this cut revive the housing bubble, it generated a new spurt of inflation that eventually pushed the CPI above the 3 percent government mandated threshold. Moreover, this hike revived the housing bubble. Real estate prices had began to slow in 2005, but following this rate cut, double digit housing inflation returned in 2006.

The consequences of this monetary mismanagement is all to evident. Having generated the greatest housing bubble in history of this island, the bank also has a serious inflationary problem. A 3 percent inflation rate may not seem like much, but the more accurate retail price index is showing a 5 percent growth rate, the highest rate in 15 years.

To summarize; the bank cut rates too much when there wasn't a need. It left them them too low when it should have raised them. When it did finally increase them, they didn't raise them enough. Then it cut rates when they should have kept increasing. Today, inflation is rising and the housing bubble is out of control. The bank needs to take some tough decisions, but being conflict-minimiser with one eye on public opinion, it will evade responsibility. Rates will go up 0.25 percent but further interest rate increases are on the way. Get ready for 6 percent by the end of the year.

Some will defend the bank and say that since it gained independence, inflation has been historically low while the UK has enjoyed strong growth. However, this is to confuse a causal relationship with a happy coincidence. Inflation has been low because developing countries like China and India have flooded the UK with cheap goods. The housing market bubble unleashed a borrowing frenzy that kept UK consumption and therefore kept growth high, but at the cost of massively and unsustainably increasing private sector debt.

In other words, today's growth was achieved a borrowing related spendfest, egged on by the housing bubble, and cheap Chinese labour. It was great while it lasted, but now it is coming to an end. On Thursday, the Bank has to start cleaning up the mess.

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