Rate rise: economics or politics?

First, what the Bank of England's Monetary Policy Committee said when raising interest rates from 3.75 to 4 per cent last Thursday: 'The world economic recovery has become more broadly based. In the United Kingdom, output growth in the second half of last year was above trend and business surveys point to a further pick-up in the first quarter. Household spending and borrowing have been resilient, and the housing market remains strong.'

When this highly paid committee of nine spends several days deliberating, every word of its occasional statements should be studied. The MPC continued: 'Although sterling has appreciated, continued growth above trend means that inflationary pressures are likely to pick up gradually over the next couple of years. Against that background, and despite CPI inflation currently below the 2 per cent target, the committee judged that an increase of 0.25 percentage points to 4 per cent was necessary to keep CPI inflation on track to meet the new target in the medium term.'

What the MPC did not say was: 'Frankly, inflation is not a serious problem. But some of us remember the Barber boom of the early 1970s and the Lawson boom of the late 1980s. We are scared stiff at the pace of increase in consumer borrowing and fear there may one day be a very nasty bursting of the bubble.'

Neither did the MPC add: 'By the way, we had already indicated rates would rise at some stage, and can do without unnecessary public hints from the Chancellor and Treasury officials that it is time.'

Last week's rise was more of a signal than anything else. It was so well advertised in advance that the financial markets hardly budged - a sure sign that Bank Governor and MPC chairman Mervyn King had, at least this time, achieved his long-term aim that changes in rates should be 'boring and predictable'.

It is ironic that, on the day of the change, and soon after the latest of the Treasury's public hints, Gus O'Donnell, Permanent Secretary to the Treasury, was telling the annual dinner of the Society of Business Economists that, following the delegation of monetary policy to the Bank, the Treasury had been 'looking carefully at what it should do and what it shouldn't do'. Intervening in interest rate decisions, however obliquely, is what it should not be doing.

But the reason for the Chancellor's concern about the timing of interest rate changes is obvious. Next year is widely expected to be election year. The Treasury proudly boasts of more than 40 quarters of continual growth, against the background of all sorts of ups and downs in the other Group of Seven economies, whose finance ministers Gordon Brown was meeting yesterday.

The Chancellor has invested heavily in avoidance of 'boom and bust'. So far his luck has held. The actions of the MPC have been important in this regard. The 'symmetry' of the inflation target means the MPC is obliged to stoke up demand in the economy when inflation shows signs of being below what is now the 2 per cent target.

In evidence to the Treasury Committee on 16 December Jon Cunliffe, who goes by the grand Treasury title of managing director, macroeconomic policy and international finance, when asked about the 'Treasury's view on the risks posed by the build-up in personal debt should interest rates start to rise', replied: 'Questions of how interest rates affect consumption are really questions for the Bank of England because short-run demand management of the economy is their job, not ours.'

As King said in a speech in Leicester last October, the Bank's strategy had been one of 'stimulating domestic demand to compensate for weak external demand in the face of a strong exchange rate'. He has also pointed out on many occasions that for most of New Labour's period in office the growth of demand has outstripped the growth of out put and 'what is unsustainable cannot be sustained'.

What is supposed to be happening now is a 'rebalancing'. The independent National Institute of Economic and Social Research recently forecast that the growth in consumer spending would slow from 2.4 in 2003 to 2.3 per cent this year and 1.6 in 2005. Meanwhile, it is hoped that exports and investment by the manufacturing sector will pick up.

The previous rise in interest rates - from 3.5 to 3.75 per cent in November - signalled that the MPC felt it had done enough to prop up demand. As Andrew Smith of KPMG notes: 'Until November, concerns about the housing and borrowing boom were subordinated to the need to support consumer spending to avoid recession.' He says the MPC's strategy has now become unclear. 'Is it targeting inflation or personal borrowing?' he asks.

Well, for all the fuss generated by the sharp rise in the Halifax index of house prices in January, the MPC's principal concern seems to be the strength of borrowing.

As Don Smith, economist at ICAP, says: 'It does seem odd that, in a world largely absent of inflation pressure ... the MPC seems uniquely concerned about upside inflation risks.' According to Smith, the MPC's unofficial focus now is 'the promotion of medium-term economic growth prospects'.

This is where the remarkably relaxed attitude of the Confederation of British Ind ustry comes in. Normally it is the first to complain about a rise, because of the impact on manufacturing costs. Now the CBI's director-general Digby Jones was in there with the Chancellor and Treasury officials, welcoming a rise in advance. The CBI thinking, like Brown's, is that it is preferable to act early to avoid panic rises later, which might take interest rates significantly higher than 'prudence' would dictate.

Yet the CBI 'recovery' survey, on which much justification for tighter money is based, has undoubtedly been overhyped. As the CBI itself says: 'The improvement is from an extremely low base following years of contraction in the troubled sector. Two-thirds of firms continue to work below capacity, jobs are still being lost and competition continues to put pressure on prices.'

'Optimism' about export prospects is put in perspective by the CBI's statement that it 'marks the first increase in export orders for over seven years'.

The world now sees interest rates in the UK significantly higher than elsewhere and generally assumed to be on the way up. This makes sterling attractive, but is not necessarily good news for the fledgling manufacturing recovery.

But what most concerns the Chancellor is that the borrowing and housing bubble should be gently deflated well in advance of the election. That is why he is so keen to advise the independent Bank of England.