Bank's balloon trick

This was one of the most widely expected rate rises for some time. Of 30 analysts polled by Bloomberg, all but one predicted that the Bank of England's monetary policy committee (MPC) would nudge up borrowing costs today.

The Bank duly did so, increasing rates by 0.25% to 4%, its second rate rise in three months, following November's increase, the first in almost four years.

Still, the Bank's decision does mark a turnaround from last month's MPC meeting, when only one of the committee's nine members voted in favour of higher rates. Sir Andrew Large, the deputy governor, argued at the time that house prices were still rising, along with consumer spending and household borrowing, despite November's move.

His arguments would have carried even more weight in the flurry of economic data in recent days. They all pointed to a pick-up in economic activity, from higher than expected growth in the last three months of 2003 to strong sales at Christmas. The clincher, though, was yesterday's report from Halifax bank.

The Halifax survey showed that house prices picked up again in January, rising 2.2%, bringing annual house price growth to 16%. The Bank has been long worried about a repeat of the boom and bust in the housing market of the 1980s. In recent years, house prices seem to be defying gravity, despite the Bank's expectations that the housing market would eventually lose steam of its accord.

This has not happened because the economy, while hardly spectacular last year, grew a respectable 2.1%. That was enough to keep unemployment at record lows and prolong the feelgood factor among consumers, who have carried on spending, borrowing and buying houses.

Even when the Bank raised rates last November from a 48-year-low of 3.5%, there were suggestions that it would take more than a 0.25% rise to cool a rampant housing market. From the most recent data, Sir Andrew's concerns seem to have been borne out, and his colleagues decided that they had waited long enough and it was time to act again.

Industrialists will have very mixed feelings about today's rate rise. Even though the battered manufacturing sector has come out of its slump, it still remains fragile and there will be fears that rising rates will abort recovery.

But, in one hopeful sign, manufacturing exports have picked up, despite the fall of the dollar, which hit an 11-year low against the pound last month. Exports have held up to the US and they have done well in the eurozone, where the euro has been appreciating. Indeed, the strength of the pound will be a constraining factor on any move to push up rates as a strong pound will hurt exports.

Industrialists might also point out that inflation - at 1.3% - is well below the Bank's target of 2%. Some analysts believe the Bank could have waited longer to raise rates because, although the recent data was strong, it was not that strong. Some predict that inflation will end this year at about the current 1.3% rate, perhaps even dipping below 1%.

But the Bank clearly felt it needed to take action. Low rates have fuelled a spending spree, record levels of household debt and a housing boom. The trick for the Bank is to let air gently out of the balloon. It hopes to do that by verbal warnings, backed by gradual rate rises. That was why it decided to hold off for the last two months.

Minutes from the Bank's last meeting said: "The rise in indebtedness of UK consumers implied increased uncertainty about the effect of a change in monetary policy on consumption and, for that reason, changes in interest rates should be gradual."

As consumers appear to have shrugged off November's rate, it was time for another dose of medicine. The era of historically low rates is well and truly over.

"If consumers start to adjust soon, then interest rates are unlikely to rise much further," said Roger Bootle, economic adviser with Deloitte. "But if they shrug off the rate rise, as they appear to have done with November's, then interest rates will continue to increase until consumers sit up and take notice."

Mr Bootle believes that rates will not go higher than 4.25% because he thinks the housing market is heading for trouble, which would obviate the need for much higher rates.

"The markets currently believe that interest rates will rise to just under 5% by the end of this year," he said. "But I think that they have underestimated the vulnerability of the housing market.

"A major downturn is just around the corner and will probably be underway come the summer, by which time interest rates are likely to have been raised further to 4.25%.

"But, with the strength of sterling on the exchanges a key concern, the Bank will be keen not to raise rates too far. So my view is that 4.25% may prove to be the peak."