'Old Lady' Looks Set to Peg Rate at Five PC but Three-Way Split on Cards; amid Growing Economic Uncertainty, a Divided Bank of England Monetary Policy Committee Is Likely to Peg Base Rate at Ave per Cent Next Week - and for Months to Come, Argues Howard Archer of Economic and Business Intelligence Group Global Insight

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Byline: Howard Archer

The Bank of England's monetary policy committee seems set to keep interest rates unchanged at five per cent next Thursday at the conclusion of its July meeting. However, this could well mask a three-way split in the vote and the future path of interest rates is currently highly uncertain.

The Bank of England is currently facing by far the most challenging economic environment since it was granted operational independence in 1997. Indeed, it is facing the most challenging environment since the early 1990's, if not earlier.

Latest data and survey evidence are now pointing consistently to a deepening economic slowdown, and the risk of recession is becoming ever more real. At the same time though, inflation is well above-target and still rising, and there are serious risks that this could prove to be more than a temporary state of affairs.

Policymakers are very aware that with consumer price inflation set to rise above four per cent over the coming months (from an already well above target 3.3 per cent in May) and inflation expectations elevated and rising markedly, there is a very real danger that high energy and food prices could have significant second round inflationary effects through pushing up the prices of other goods and leading to higher wage growth.

This could lead to a damaging wage-price spiral developing, which the Bank of England is determined to prevent. The bank therefore believes that some slowdown in growth is needed to create spare capacity and keep down price and wage pressures.

At the same time though, the Bank of England is very aware of the mounting downside risks to economic growth, and has highlighted the importance of avoiding a slowdown that is so sharp that it pulls inflation below its two per cent target on a two-year horizon. The increasing squeeze on consumers' purchasing power from high inflation, the sharply weakening housing market and ongoing tight credit conditions all pose significant and heightening downside risks to growth.

Furthermore, unemployment is now rising, while business are paring back their investment plans markedly. While the weaker pound is providing a welcome boost to UK exporters, this is being countered by slowing growth in key export markets, notably the US and the Eurozone.

On top of this, the housing market downturn is deepening, increasing the likelihood that an extended, deep correction could occur, with potentially serious repercussions for the rest of the economy.

Worryingly, the latest data and survey evidence clearly point to a deepening slowdown.

In particular, the purchasing managers' surveys showed contracting activity in June in the services, manufacturing and construction sectors.

Consumer confidence sank to an 18-year low in June and most of the evidence points to consumers increasingly reining in their spending despite a reported sharp jump in retail sales in May. Meanwhile, the Bank of England has reported that credit conditions tightened further in the second quarter of 2008, which does not bode well for domestic demand.

The MPC voted 8-1 in favour of keeping interest rates unchanged at five per cent at their June meeting, with arch-dove David Blanch-flower being the sole dissenter and calling for a 25-basis point cut to 4.75 per cent.

However, the minutes revealed that some MPC members mulled whether an immediate interest rate hike was justified.

Four MPC members - Timothy Besley, Paul Tucker, Sir John Gieve and Kate Barker - subsequently revealed in testimonies to Parliament's Treasury Select Committee that they considered the case for an interest rate hike in June, before coming down in favour of keeping rates at five per cent.

It is also likely that the usually hawkish Andrew Sentance considered a rate rise at the June MPC meeting (he did not testify to the Treasury Committee).

Consequently, the MPC appears to currently hold a modest tightening bias and an interest rate hike later this summer is clearly very possible, particularly if workers do start winning higher pay awards. …