British and European central banks stick to the script

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The Bank of England’s rate rise on Thursday – a quarter of a percentage point to a six-year high of 5.75 per cent – may have been predictable, but it will give consumers pause for thought. The European Central Bank meanwhile kept rates steady at 4 per cent, but signalled that markets can expect a rise later this year. Despite some doubts over the future direction of UK and European inflation, the decisions were correct, albeit a month too late in the case of the BoE.

The UK rise came four weeks after Mervyn King, the governor, was outvoted 5-4 in the Bank’s decision to keep rates steady despite signs of persistent inflationary pressures. Back then, some voting with the majority were concerned about surprising markets. That clearly was not a problem on Thursday.

The signs that were apparent last month still exist today: growth is strong in the UK and most parts of the world, consumer spending remains high, and there are still ample supplies of money and credit. Add to that high oil prices and strong equity markets and you have a formula for an inflationary threat.

But alongside these pointers, there are two substantial British economic uncertainties on the horizon: first, even with strong domestic growth, the UK labour market looks surprisingly weak. Neither wages nor employment have kept pace with output growth. Yet business surveys point to companies itching to raise prices in the near future.

Second, the path of UK consumer spending could slow in the autumn as many homeowners are coming off fixed mortgages. Low interest rates in the back half of 2005 encouraged many consumers to take out new loans, many of them with guaranteed rates set for two years. As interest rates adjust upwards by as much as 1 to 1.5 percentage points, consumers might cut their spending in other areas. This holds particularly true with an already low savings rate and consumers borrowing against their homes to foot their bills.

Both factors mean that consumption could turn quickly in the months ahead and make future inflation and rate decisions less certain. If UK labour markets remain weak and increased mortgage rates have adverse effects on spending, the Bank may not want to raise rates to 6 per cent before the end of the year, as many expect.

But none of this should have prevented action. Self-sustaining growth – with no contagion from the sluggish US economy – calls for higher interest rates. The BoE has done its part. The ECB might follow suit when it gets its next chance.

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