Bank signals further rise in UK cost of borrowing

The introduction of the word "slightly" marked a moderation of tone from that in the Bank's last quarterly inflation report in May, in which it declared the risks to inflation were "weighted to the upside in the medium term". This may leave open an outside chance that rates have peaked already.

The Bank's latest inflation projection is based on market yields implying base rates will edge up and sit at a level of 6% through the first half of next year.

Financial markets are pricing in little scope for a subsequent cut, assuming base rates of 5.9% in the second half of next year and throughout 2009. While such market assumptions can change rapidly with events, the Bank of England did nothing yesterday to alter them with a report showing it remains on inflation alert.

On the basis of constant base rates of 5.75%, a separate graph in the inflation report shows annual CPI inflation significantly above 2% two years out.

A poll published last night by news agency Reuters showed a growing majority of economists now expects UK base rates to hit at least 6% this year, with 37 of 52 predicting such an outcome and only 15 believing the peak has been reached. The median probability attached to rates hitting 6% rose further to 75%, from 65% only last week.

Twenty-four of 61 economists had said last week that they believed rates had peaked - a proportion of 39% which was a far cry from the 29% in yesterday's poll.

Those economists expecting another rise view the September or October meeting of the Bank's Monetary Policy Committee as the most likely to bring another increase in borrowing costs.

The Bank says in yesterday's inflation report that "consumer spending growth appears to have been surprisingly resilient" in the face of five quarter-point increases in UK base rates since the latest monetary tightening phase began in August last year.

It highlights the resumption of upward pressure on import prices. In this context, it cites the renewed jump in oil prices, since the start of the year, and the rising cost of other commodities.

The Bank also emphasises a seeming lack of spare capacity in the economy and its expectations that already punchy official UK growth figures could be revised up further, while pointing to signs that expansion remains firm in the third quarter. It notes surveys signalling that the general public's inflation expectations, which may have been fuelled by a rise in the annual CPI measure to a level of 3.1% in March which was the highest since comparable records began in January 1997, "have not as yet fallen back as inflation has moderated".

The Bank says survey measures of businesses' pricing intentions "remained elevated", particularly in manufacturing, and adds it is "possible that heightened capacity pressures are affecting companies' pricing behaviour".

Bank of England governor Mervyn King was sanguine yesterday on the issue of home repossessions which, according to figures last week from the Council of Mortgage Lenders, rose to their highest level since 1999 in the first half of this year.

He said: "The scale of repossessions is markedly below the level we saw in (the) late eighties and early nineties - roughly one-quarter of rates then That doesn't in and of itself constitute a major macroeconomic threat."

Hawkishly, no doubt with an eye on the continuing rise in residential property prices, King added: "We have been surprised over the last year or so by the strength of the housing market We obviously monitor it very carefully. We're thinking deeply about its interaction with consumer spending, and its impact on borrowing and debt. We do follow carefully what's going on."

In the inflation report, the Bank also cites a strong outlook for business investment and exports.

King highlighted the fact that UK growth had been above its long-run average rate for six consecutive quarters, according to figures from National Statistics, and pointed out business surveys had been "even more upbeat". He cited the need for a slowdown in demand growth to keep inflation close to target. King also highlighted "buoyant" world economic activity.

Although citing "greater-than-usual" uncertainty about the inflation outlook, King gave a clear signal of intent on rates.

He said: "Indicators of pricing and capacity pressures remain particularly important. If they do not fall back, that would be consistent with the upside risks to inflation crystallising."

King was unperturbed about the recent turbulence in credit markets, which have seen a significant repricing for riskier debts at a time when highly-leveraged buy-outs by private equity groups have been to the fore.

These market developments have led to the postponement of the auction of cable television provider Virgin Media, which had attracted the interest of venture capitalists.

King said the tightening of credit conditions mattered only to the extent that it affected the macroeconomic environment and so far the impact had been small. He also welcomed the "more realistic approach" to risk.

Annual CPI inflation had by June fallen back to 2.4%. The MPC continues to expect it to ease in the near term with falling gas and electricity prices, although to a lesser extent than forecast three months ago because of higher oil prices and reduced spare capacity. The Bank of England also highlights the potential for higher food prices, arising from recent floods, to affect the short-term picture.

However, the MPC's focus in any case remains on threats to the medium-term inflation outlook. The Bank's report yesterday notes the latest inflation forecast is, further out, "marginally lower" than in May because of a weaker projection of output growth, although these calculations are based on higher market interest rates.

The most recent of the five rises in UK base rates this cycle, on July 5, went through on a six-to-three vote. The MPC stood pat last Thursday, and minutes of this latest meeting should give further clues on the monetary policy outlook when they are published on Wednesday next week.

Liberal Democrat Treasury spokesman Vince Cable said in the wake of the inflation report: "There is now a clear consensus that rates will have to rise further due to powerful inflationary forces in the world economy, notably rising energy and food prices.

"The continuing surge in British house prices, driven by rapidly-expanding consumer credit, is also causing pressures. It seems that the Bank of England will have no choice but to raise interest rates.

"The position of heavily-borrowed families with large mortgage obligations is becoming seriously grim. It is difficult to foresee anything other than a continuing rise in the number of people facing repossession and personal bankruptcy."

Richard Lambert, director-general of the Confederation of British Industry and former member of the MPC, urged his erstwhile colleagues to exercise caution on the rate front.

He said: "Despite the recent rise in oil prices and possible pressures on food prices because of the recent flooding and bad weather in Europe, the Bank should be cautious about any further increase in interest rates in the coming months.

"Pay pressures are subdued and there are signs that the impact of the five rate rises since last summer is beginning to take its toll on the economy, and the full effects are clearly yet to be felt."

Howard Archer, chief UK economist at consultancy Global Insight, said: "The impression we get from the quarterly report and Mervyn King's accompanying remarks is that interest rates are more likely than not to rise to 6% in the autumn, but the Bank of England is in no immediate hurry to raise interest rates again given the current major uncertainties surrounding both the inflation and growth outlooks.

"These uncertainties are currently being compounded by global equity market turmoil and widening credit spreads, although for now at least the Bank of England seems reasonably relaxed about these."