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Will the BoE Keep Writing Letters?

Anjuli Davies,|Special to CNBC.com
Wednesday, 9 Jul 2008 | 12:36 PM ET

The Bank of England's Monetary Policy Committee will find itself in no easier position on Thursday, as it meets again to decide on UK interest rates.

"We're facing a situation of rising inflation and falling growth," King said as he went before the Treasury Select Committee last month to defend the Bank's policy. "We're certainly not relaxed in any way."

With rates currently set at 5 percent, on hold since the MPC's May meeting and an 8-1 vote in June to keep them there, there seems no alternative but to wait, see and keep writing letters.

"I'm expecting they will sit on their hands," Ex-MPC member Willem Buiter, Professor of European Political Economy at the London School of Economics told CNBC.com. "But they should be raising rates. Inflation is above target and they overestimate the ease at which the economic slowdown, which is indeed severe, will squeeze inflation."

Buiter predicts that the Bank of England would probably begin to raise rates in August, when it releases its next inflation forecast, with at least two rate increases by the end of the year.

"CPI will keep on rising and will go through the 4 percent barrier by the end of the summer and could stay high for a while," Buiter said.

Other economists, however, think the bank should cut the rates now rather than later.

It is "reasonable for the MPC to toe the line and do nothing," Jonathan Loynes, Chief UK Economist at Capital Economics, told CNBC.com. But "the problem is the longer rates stay on hold, the deeper the economic downturn and the further rates will have to fall once inflation eases."

BoE's Inflation Headache
If inflation expectations continue to rise sharply the Bank of England may have to increase interest rates soon, Brian Farthing from PriceWaterhouseCoopers told CNBC Thursday.

Capital Economics is forecasting a 25 basis point cut in December followed by aggressive rate cuts in 2009 that could see the base rate brought down to 3.5 percent by August 2009.

Housing Market Recession?

And whilst CPI continues to rise, hitting 3.3 percent in May and forcing the Governor to put pen to paper, concerns in the housing market continue to rage. Mortgage approvals continue to fall along with house prices and the homebuilders are particularly feeling the pain. The Home Builders Federation (HBF) is again calling for a 50 basis point cut in rates.

"The housing market is in recession and should be a priority. The Bank of England can't use models based on previous downturns this time round. The implications of deteriorating housing market could cause serious economic problems," Steve Turner from the HBF told CNBC.com.

Despite the fact that Capital Economics is forecasting that CPI could reach 4.5 percent by the end of the summer, Loynes told CNBC.com that he had sympathy for the homebuilders.

"The latest news on the housing market is pointing to something catastrophic," Loynes said.

He said even though there had been a bubble in the housing market, its burst could have a "huge impact" on the economy, jobs and the standard of living.

"The MPC should be worrying about it in a big way. They should be cutting very sharply, not to re-inflate the bubble, but to limit the affect on the rest of economy," Loynes added.

What really matters for the MPC is where the inflation figure is likely to be in several years in the future, he said, and there is no reason why price rises shouldn't cool off.

"High food and energy can't carry on rising ad nauseam unless there has been a permanent trade-off between growth and inflation, but I don't think there is any reason to think that," said Loynes.