Posted on 14-5-2004

Bank Warning - UK
by Larry Elliot, May 13, 2004, The Guardian

Labour may be forced to fight the next general election against a backdrop
of higher interest rates, rising inflation and a rapidly cooling housing
market, the Bank of England warned yesterday.

In its quarterly health check of the economy, the Bank dropped the
broadest of hints that further increases in the cost of borrowing were in
the pipeline following last week's rise to 4.25%.

The Bank is forecasting that inflation will gradually pick up in 2005,
even though the economy, and the property market in particular, will be
slowing. June of next year is seen as the likeliest timing for polling
day, and the government plans to make the strength of the economy the
centrepiece of its campaign for a third term.

Last night the City was pencilling in rates of about 5% by the summer of
next year in response to hawkish comments from the Bank explaining why it
raised rates despite inflation being well below its 2% target.

Mervyn King, the Bank's governor, told a press conference: "The view that
the market has been taking lately - that further increases in interest
rates may be necessary - is not an unreasonable one."

The Bank's two-year forecasts in its inflation report predicted that
growth would remain robust in the short term but then start to ease back.
"Overall, the outlook for GDP growth is stronger than expected in the
first year of the projection, but weaker thereafter."

It added that the change in its view since the last inflation report in
February had been affected in part by movements in the housing market.

The projection from the Bank's monetary policy committee is "for house
price inflation to slow sharply during the next two years, though house
prices may well continue to rise strongly in the near term".

The Bank stressed that the ratio of house prices to earnings was above a
sustainable level, even accounting for a background of lower inflation and
cheaper borrowing costs.

"Although there are several reasons to suppose that the ratio of house
prices to earnings might remain higher than in the past, it is hard to
believe that they can account for the full extent of its recent rise. At
some stage, therefore, house prices are likely to rise more slowly than
earnings."

Latest figures from Nationwide and the Halifax suggest house price
inflation is running at almost 20%, though data collected by the Office of
the Deputy Prime Minister point to a much lower rate of growth of just
under 8%. Average earnings are rising at an annual rate of just over 5%.

The report predicted a rise in the cost of servicing debts as interest
rate increases start to bite. Over the next two years, the Bank believes
debt servicing costs may rise to "levels last seen in the early 1990s, but
not necessarily the level of the previous peak in 1990".

Mr King said the lower level of rates compared to the 80s meant borrowers
were less vulnerable now; rates would have to hit 9% for borrowers to face
as big a problem as they did 15 years ago.