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Bank of England governor Mervyn King has fought off demands from hawks on the monetary policy committee to raise interest rates and was quickly vindicated by the latest estimates for growth in January showing the UK economy remains weak.
The MPC has kept base rates unchanged at 0.5% for the 23rd month running and maintained its programme of quantitative easing at £200bn at its monthly meeting.
King, who defended his determination to keep rates low in a speech last week, led a majority of MPC members who believe that an interest rate rise would only weaken the economy and hurt homeowners and businesses desperately in need of cheap credit.
City economists had estimated there was a 20% chance of a rate increase after a sustained rise in inflation to 3.7%. Many analysts believe rates will start to rise from May at the latest as MPC members are forced to put aside their fears for the economy and tackle escalating inflation.
Their expectations were reinforced by the Bank’s deputy governor, Charles Bean, who said last week the MPC might be forced to raise borrowing costs if the food and commodity price booms continued.
Stephen Boyle, head of RBS group economics, said: “It is a question of when – not if – rates start to rise in 2011. My forecast is for a first hike in August, but we are at the point where every meeting will be a close call. One big number on growth or inflation could be decisive.”
Figures out next week are expected to show inflation for January jumped above 4%, more than 2% above the MPC’s inflation target of 2%, with the prospect of it nearing 5% before the summer.
MPC member Andrew Sentance has consistently argued that rates need to rise before businesses begin to raise prices and workers to increase wage demands to cope with higher inflation. At last month’s meeting Martin Weale, the newest member of the committee, joined Sentence in arguing for a rate rise to 1%.
However, King has insisted that even a modest rise in interest rates could harm the recovery, which already faces severe headwinds from government spending cuts and weak domestic demand. King also stressed that much of the UK’s current inflation was a result of a rise in VAT to 20% and a spike in food and commodity prices that is expected to ease by next year.
Roger Bootle, economic adviser to the accountants Deloitte, said King’s analysis would be vindicated by events over the coming months. “The MPC is right to resist calls to raise interest rates to defend its credibility. Given the huge amount of uncertainty about the underlying strength of both economic growth and inflation, the committee would be foolish to rush into a premature tightening of policy.
“Indeed, as the fog clears, it should become clear that interest rates need to remain at an ultra-low level indefinitely,” he added.
A report by the National Institute for Economic and Social Research (NIESR) reinforced concerns that the economy is struggling to grow, even with low interest rates in place.
Separate figures also showed that output from Britain’s snowbound factories declined in December for the first time in eight months, with an unexpected fall of 0.1% underlining the fragility of the economic recovery.
NIESR said an assessment of GDP growth in January found that although the economy had expanded by 0.6% on the previous month, work carried over by companies from snow-hit December into January explained almost all of that improvement and therefore the economy had remained flat.
The study followed official figures last month which revealed that the economy contracted by 0.5% in the final quarter of last year. The Office for National Statistics blamed the December snowfalls for the contraction and argued that without the snow, growth would have fallen to zero.
“The underlying level of GDP appears relatively flat over the last few months, suggesting the output gap [the gap between potential output and actual output] is widening,” said NIESR.
Its estimates are regarded as providing a good indicator of official figures. Earlier this month NIESR urged the government to consider a Plan B to resuscitate the economy. It said there was an opportunity to delay spending cuts when the chancellor delivered his budget in March.
The British Retail Consortium’s director general Stephen Robertson welcomed the continued freeze on interest rates as a “wise move”. He added: “At a time when consumer confidence is weak and the housing market is slow, raising rates could only have done harm.”
Lee Hopley, chief economist of employers’ group the EEF, said: “While there remain considerable risks to inflation, the recovery has hit some turbulence in recent months. The MPC is right to hold off on rate rises for now as an increase will do little to alter the path of inflation in the short term, which is being driven higher by commodity prices and tax. The MPC should continue to hold steady until the picture becomes clearer and the economy is firmly back on an upward track.”