Business rebound raises rate fears

Evidence that the economy rebounded strongly in the second quarter of the year yesterday increased City fears that the Bank of England would raise interest rates in August.

After an unusually weak performance in the first quarter of the year when output expanded by 0.5%, the economy recorded 0.9% growth in the three months to June, according to a preliminary estimate from the Office for National Statistics. The annual rate rose to 3.1%, its highest since the first quarter of 1998 and well above the Bank's estimates of the level of growth consistent with stable inflation.

Manufacturing posted modest growth, though at this early stage the ONS does not give an exact figure. Services expanded by a robust 1.0%.

City hawks seized on the data as evidence that interest rates have not yet reached their peak. "At some point soon, base rates are likely to have to rise to ensure that growth does slow to trend quickly," said Michael Saunders, from Citybank. "The longer that growth stays above trend, the greater the risk that capacity strains rise so much that the MPC eventually needs to slow growth below trend to keep inflation on target."

Interest rate markets seemed to agree. The December short sterling contract fell five ticks to 93.52 after the data, implying at least one more quarter point rise in borrowing costs before the end of the year.

Richard Iley from ABN-Amro noted that there was not much room for the boost in demand given by Gordon Brown's ambitious public spending plans. "In conjunction with stronger than expected retail sales data and fresh evidence of strong consumer borrowing also released this week, today's data should confirm that the much talked about slowdown in domestic demand growth is chimerical," he added.

Other analysts said much of the rebound was due to bad weather in early summer which increased energy consumption. "The underlying growth rate is rather softer than the headline numbers suggest," said Jonathan Loynes from HSBC markets. "Smoothing this effect out, the average growth rate of 0.7% per quarter in the first half of the year is broadly consisent with the cycle having peaked in the third quarter of last year."

The economy has been expanding for 32 quarters, a post-war record, according to the ONS. As a result of revisions to older data, the last three months of 1998, which had showed no growth, now shows a gain of 0.2%.