What happens after the rate increase

Today we continue with our pick of media analysis of interest rates in the UK. Failing a complete shock the rates are expected to rise 25 basis points to 5 percent this week.

As we outlined yesterday, the Reserve Bank of Australia increased rates to 6.25 percent with strong hints that this will not be the last in the series. So it seems that sentiment globally is that rates are not only up, but still have further to go. All eyes will be focussed on the ECB and Fed afterwards.

BN has been analysing various reports and presents its case below-

In recent weeks we have noticed a sharp change. Whereas, not so long ago, many believed rates would fall back next year, with Capital Economics, for example, predicting a return to 3.5 percent in 2007, now the thinking seems to be that inflation has to be nipped in the bud. And that central banks must raise rates, perhaps more than once, and keep them there until inflation is well and truly slain – and that, goes the argument, could take several years.

Yesterday two quite different, and normally quite dovish, groups threw their pennies worth into the equation. The Royal Institute of Chartered Surveyors, a group that normally sees its members’ interests best served by having rates low, and the doves of the economic world – Capital Economics, seem to fly the nest, and become swooping hawks, urging the central banks to take a tough line.

RICS thinks we need to move fast, or otherwise things will get more serious. Yesterday, its chief economist Milan Khatri said: "The recovery of the economy this year has exceeded all expectations, the stock market is at its highest level for over 5 years and there has yet to be any noticeable negative impact from the August interest rate rise on the economy or the housing market…The experience of late 2003 and 2004 shows that it takes several rounds of interest rate rises to take the heat out of the housing market when the economy is performing well".

And Capital Economics applied economic theory to the problem as it warned yesterday: "Higher rates and weaker growth may bring little or no immediate reduction in inflation. Central banks need to be prepared to sit it out. Interest rates may need to be kept high for an extended period."

BN then goes on to discuss the Philips Curve which suggests that there is a relationship between inflation and unemployment. Though the Philips curve is now manly disregarded, there may be other factors coming into play that dilute the effect – for example the rapid growth of technology and globalization.

Hidden in the text is an issue that we feel should be raised in profile. The housing market is slow to react to increases, this has been borne out in the UK with recent surges in prices despite increases in rates.

In effect, the consumer has been conditioned to think that capital gain in property is guaranteed, and that some short-term pain in the form of higher repayments will be outweighed by those capital gains. As the article points out, the requirement may to hold rates longer than originally expected and in potentially a further increase may be required to solidify the message to the consumer.