Business-Insider

The Bank of England Monetary Policy Committee (MPC) faces a very important interest rate decision this Thursday as policy mistakes now could prove costly.

After a surge in headline consumer inflation at the beginning of 2007, the rate has started to moderate as big price increases last year are coming out of the calculation.

There are still concerns that underlying inflation is edging higher and the bank will need to keep inflation expectations under control. The headline rate is also still significantly above the 2.0% target at 2.5%

The economy is still growing steadily and house prices have remained strong even though there is evidence of an underlying deterioration in conditions. Consumer spending levels appear to have weakened slightly.

Failure to increase interest rates this month would risk damaging credibility, but a decision to increase rates when the economy is already slowing would risk a very sharp economic downturn later in 2007.

The recent comments from Bank of England officials suggest that a unanimous vote is unlikely this week. Indeed, it is certainly possible that the decision will be very close and a rate increase is by no means certain as there will be some votes for unchanged rates.

The evidence suggests that Bank Governor King will again vote for an increase and will exert pressure for dissenters to back his judgement this time around.

If interest rates are increased, the statement accompanying the decision will need to be watched closely to assess future policy decisions. If rates are held unchanged, there will not be a statement.

Overall, there is around a 70% chance that rates will be increased with the MPC deciding that an increase can be reversed quickly if necessary. There has been some speculation over a 0.5% increase, but this option should be rejected.

Sterling has effectively fully priced in a rate increase this month and the UK currency will weaken sharply if rates are not increased.

The UK currency should strengthen initially if rates are increased, but gains will probably not be sustained and Sterling could well end up with net losses, especially if the statement expresses doubts over a further increase.

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Tim Clayton
Investica Ltd Head of Research
Forex Factory Analyst