BoE raises interest rates to 5.25%

Interest rates hit their highest level in more than five and a half years on Thursday after the Bank of England surprised the City by raising the cost of borrowing to 5.25 per cent.

The quarter of a percentage point increase wrong-footed analysts, most of whom had expected the Bank’s monetary policy committee to stay its hand this month, before possibly introducing an increase in February.

Sterling and yields on government bonds jumped as the Bank said it had made the move because “the margin of spare capacity in the economy appears limited, adding to domestic price pressures.”

Domestic demand was growing steadily, while “credit and broad money growth remain rapid.”

“It is likely that inflation will rise further above the target [2 per cent] in the near term, but then fall back as energy and import inflation abate. Relative to the November Inflation Report, the risks to inflation now appear more to the upside,” said the Bank in a statement accompanying its decision.

The immediate business response to the Bank’s move – which came as the European Central Bank kept eurozone benchmark interest rates on hold at 3.5 per cent – was mixed.

Graeme Leach, chief economist at the Institute of Directors said: “This was a tough but wise decision. The MPC needed to stamp down on inflation given the upside risk at present.”

However, Ian McCafferty, chief economic adviser to the CBI, the employer’s body, said: “It is disappointing that, with only tentative indications about the outcome of the wage round, the Bank has already decided to increase interest rates. If part of the intention was to dampen wage increases, it is doubtful a rate rise will have the desired effect.”

A recent Reuters poll had shown that only one out of 50 economists thought the meeting would end with news of a quarter of a percentage point hike.

UK government bond prices tumbled and yields rose dramatically as traders confessed they were stunned by the Bank’s move.

“Hardly anyone was expecting this, so we saw some big moves at the short-end of the curve,” one London-based trader said.

The two-year gilt, due to mature in March 2009, which is also very sensitive to rate rises, saw yields rise by about 12 basis points – a “big, big move” in the words of one trader. At the longer end of the curve, the 10-year gilt due to mature in September 2016 saw yields rise by about 6 basis points.

Sterling jumped by 1.1 per cent against the dollar to $1.9530 and by 0.5 per cent to £0.6660 against the euro.

The Bank’s surprise move also wiped out early gains for the FTSE 100 index of leading stocks. Having traded 38 points higher before the Bank’s announcement, the FTSE 100 was down 16.2 points at 6,144.5 in early afternoon trade. Real estate, housebuilders and property-backed pub companies bore the brunt of the sell-off.

The move shows that Mervyn King, Bank governor, and the majority of his colleagues on the rate-setting body felt immediate action was needed in order to tame inflation.

The consumer price index rose by 2.7 per cent in November, the seventh month it has been above the Bank’s 2 per cent target, and recent data suggest the economy is showing little signs of cooling in response to last year’s two quarter point interest rate increases.

Since the turn of the year, the City has had to digest a survey of service companies that showed the sector growing at its fastest pace in nearly 10 years; strong numbers on mortgage lending, which suggest the housing market will remain buoyant at least into the spring; and a stronger than expected report on retail sales over the important Christmas period that shows consumption growth proceeding at a reasonable clip.

In addition, data released on Thursday showed the manufacturing sector rebounding in November after three months of contraction.

Mr King may remain sanguine that the High Street was able to confound fears of a poor Christmas 2006 – he believes it will take until the Spring before the true outcome of festive season retail sales are revealed – but he is likely to have been concerned by evidence of bubbling inflation in the shops and elsewhere.

The British Retail Consortium on Wednesday said that retailers pushed up prices by 2.28 per cent in the 12 months to December, the fastest pace of inflation since March 2004.

Competition on the High Street previously had resulted in a near year-long period of deflation, but the December numbers now represent the sixth consecutive month of price rises and suggest that retailers are enjoying more pricing power.

Should this trend continue, it would make it more difficult for the Bank to bring headline consumer price inflation back down from the current 2.7 per cent to its 2 per cent target.

In addition, the Bank is wary of the public’s perception of rising inflation feeding through to wages. Early indication from Income Data Services, a research company, are that pay settlements are averaging about 4 per cent, just above the 3.9 per cent of the benchmark Retail Price Index.

In a note previewing Thursday’s MPC decision, Ben Broadbent at Goldman Sachs, had encapsulated the views of many apparently reluctant hawks in the City when he wrote:

“Following significant upward surprises to both growth and inflation indicators in the past month and we have changed our interest rate call and now expect the MPC to hike official rates to 5.25 per cent at the February meeting.”

However, it is now clear that the MPC felt it could not wait another month before sending its message.