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Thursday January 20, 2005 - 13:42:15 GMT

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Bank to resist UK rate cut

The domestic growth trends suggest that the Bank of England has judged interest rates well over the past year. Over the next 3-4 months there is likely to be conflicting evidence on the economy with the risk of higher underlying inflation offset by housing-market weakness. With the government pumping cash into the economy ahead of a May election, inflation will remain a threat and a rate cut before the election would be dangerous. The risks are finely balanced, but there is the potential for a further 0.25% increase before a late-2005 cut.

Mixed economic data

The Bank of England has left UK interest rates unchanged at 4.75% since August. The recent economic data has remained mixed with no decisive direction. The latest CIPS indices recorded a slowdown in the manufacturing and services sectors and mortgage lending remains weak. The latest house-price data, however, showed some improvement from November levels and overall spending levels appear firm despite some high-profile weaknesses on the High Street.

Inflation is not dead

The latest inflation report was above expectations for the second month in succession with the annual consumer inflation rate increasing to 1.6% for December from 1.5% in November. Oil prices have declined from peak levels and the December increase may have been seasonal. There will, however, be concerns over underlying inflation pressure. The service-sector inflation has also increased to above 4.0% for the first time since 2002 and there has been a further increase in earnings growth. The RPI inflation measure, used as the main inflation measure until last year, is also running at an annual rate of 3.5%. The Bank of England will, therefore, certainly need to avoid complacency over inflation.

Housing sector will remain crucial

There has been a slight retreat in house prices over the past few months and activity has eased with a sharp drop in mortgage lending and approvals. The level of long-term interest rates will be closely watched as the decline since the third quarter will lower the interest rates charged on fixed-rate loans/mortgages. There is the risk that lower rates will release pent-up housing demand. The housing valuations are still extremely high in relative terms and this will make it very difficult for the market to advance strongly again. The longer-term risks remain skewed towards lower prices, but the bank will not want to re-inflate the sector in the short term.

Rapid government spending increase

The bank will be concerned that the government’s budget policy is too expansionary with strong and sustained increases in spending. The budget deficit has been widening consistently and the latest annual spending increases were running at over 17%. Political factors will also start to become important with a general election highly likely in May. There will be pressure for the government to maintain strong spending ahead of the vote and the bank will also be reluctant to change rates during a political campaign.

What could go wrong?

A renewed rise in oil prices would increase concerns over inflation and could force rates higher. International rate trends should not have a major impact, although US rates will continue to increase. The Achilles heel of UK economic management has often proved to be Sterling. Any sharp decline in the currency, potentially triggered by widening trade and budget deficits would force the Bank of England to increase interest rates to keep inflation under control even if there was evidence of an economic slowdown. Any rapid deterioration in the housing sector would increase pressure for sharp rate cuts, but Sterling weakness would complicate the task. The risks still look relatively low in the short term, especially as the US dollar is likely to remain weak, but Sterling’s risk profile will deteriorate during the year with increased unease over the twin UK deficits.


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