Rate hold fuels City speculation

Managing an economy which is going in two completely different directions is no easy task, as the Bank of England's deputy governor Mervyn King admitted recently.

Today the bank opted to leave interest rates on hold at 5.25% to no-one's surprise. The manufacturing sector may be flat on its back but domestic demand has remained robust, and the bank fears further cuts to rates will simply power more consumer spending.

What is more intriguing is the disparity of views among City economists about which way the bank will take borrowing costs next. Some are already pencilling in a rise in rates, although few expect the MPC to move before the autumn. Others are still expecting one final cut to rates from their current level of 5.25%.

The division of views in the City reflects the divided fortunes of the economy. Those economists who think that demand is outstripping the supply capacity of the economy to the point where Britain could be facing a resurgence in inflation expect or perhaps want the bank to damp down consumer spending with higher borrowing costs.

On the other side, the camp expecting a rate cut are worried that manufacturing which has scarcely grown for five years is back teetering on the brink of recession.

The problem for the bank is that the high level of the pound which is strangling industry is also keeping inflation under control. While it recognises that sterling is overvalued against other world currencies, it fears that a sudden collapse in the pound would spark inflationary pressures and force the bank to put up rates.

Rebalancing the economy using monetary policy alone is tricky. The three cuts to interest rates since the start of the year have not been enough to revive manufacturing, but they have given the already robust consumer even more enthusiasm for spending.

The alternative to using interest rates to manage the economy - the one club golfing policy which Nigel Lawson once derided - is fiscal policy. A sharp rise in taxes or cut in government spending would take some of the steam out of domestic demand, but is politically almost impossible given Labour's election pledges to invest in public services and not to raise income taxes.

In the absence of any fiscal tightening, the monetary policy committee is likely to leave rates where they are while it reads the inflationary tea leaves. The economy is delicately poised, and as Ciaran Barr from Deustche Bank pointed out yesterday, consumer confidence could prove fragile if service sector firms which are already feeling the chill winds of the economic slowdown start to layoff workers.