Driven by the fear of bust and boom

There were red faces in the City yesterday when the Bank of England announced that interest rates were going up. Straw polls had shown that the Square Mile's lavishly paid economic brains were unanimous in believing that the cost of borrowing would remain at 5%.

However, the City post-mortem examinations should focus on the televised press conference by the Bank's deputy governor, Mervyn King, to launch last month's quarterly inflation report - an assessment of whether Threadneedle Street has got monetary policy on track to hit the government's 2.5% target.

Mr King was the only member of the nine-strong monetary policy committee to vote against the June reduction in interest rates. He told the press conference that the real question facing the committee was how long the benign low-inflation environment would last.

Clearly, in early August Mr King needed more ammunition before he could convince at least four of his colleagues to support his stitch-in-time approach. The past month has provided him with the bullets.

First, there was evidence of a surge in demand, driven by consumer spending. In the second quarter of 1999, household spending grew by 1.4% and was up by 4% on a year earlier. Investment was also up strongly, by 6.7% as an annual rate.

Growth forecasts for 1999, which were clustered at around 0.75% in the spring, have now been revised to 1.5% - the top end of the range laid out in the March budget by Gordon Brown. Consumer demand is expanding more quickly than the chancellor expected, while the current account is looking worse than predicted.

As far as the Bank is concerned, we have been here before. In 1986 and 1987, strong consumer demand and rising imports were early warning signals of an overheating economy, even though the headline rate of inflation was low.

There was a third element to the late 80s bubble - a boom in house prices, and here again the past month has had uncomfortable echoes of a decade ago. Indicators show prices rising at an annual rate of close to 10%. One forecast suggests that with unchanged interest rates, house prices could soon be rising at 25% a year.

The real worry at the Bank is not property prices but the prospect of homeowners sitting on big paper gains withdrawing some of their equity to fuel higher spending, thereby driving up prices. This was a feature of the late 80s and figures have shown that it may be starting to happen again. Equity withdrawals totalled £2.8bn in the first three months of 1999, up from £600m a year earlier.

Consumers also tend to spend more when they feel secure in their jobs. Last month saw the number of people out of work and claiming benefit fall by 33,000 - the biggest drop for almost two years.

Finally, the MPC has been influenced by the decision of the United States Federal Reserve to raise rates in August in response to the continued strength of the American economy and a quicker-than-expected recovery in global growth after the Asian crisis. The International Monetary Fund has revised upward its forecasts of world expansion from 2.3% to 2.8%, and higher global demand will push up commodity prices - already reflected in a doubling of the cost of a barrel of oil to $21 - and raise demand for British goods.

With all this going on, it might be assumed that Mr King had an easy job convincing the MPC to back him. Not necessarily. Last week, two members - DeAnne Julius and Sushil Wadwhani - gave interviews in which they articulated different arguments.

Ms Julius said structural changes in the economy might mean higher levels of growth were consistent with stable inflation and that falling unemployment did not automatically lead to inflationary pressure in the labour market. Mr Wadwhani said the MPC should follow the Fed, which for a long time allowed the United States to grow at a faster rate than economists believed was compatible with stable prices, without stoking up an in flationary boom. The doves on the MPC argue that looking back to the high inflation of the 80s is not a good guide to what will happen in the future. Despite more than six and a half years of falling unemployment, there has not been an explosion in pay deals, which are still running at around 3%.

The strong pound and a glut of global goods have meant cheaper imports, and this has fed through into the inflation figures. In the 12 months to August, the headline inflation rate stood at 1.3% and the rate excluding mortages was 2.2%, comfortably below the target. Prices are actually falling in large areas of the high street, with clothing and footwear 4.8% cheaper than a year ago.

This trend may continue. Competitive global markets will keep downward pressure on prices. And there are those who believe new technology will raise productivity and usher in a new golden age of low-inflationary growth. For the time being, however, the Bank's fear of the past is stronger than its faith in the future.