Investors startled by increase in Britain essay

Interest rates in Europe still increasing
Investors startled by increase in Britain
By Heather Timmons and Carter Dougherty
Published: January 11, 2007

LONDON: Interest rates in Europe are headed higher as economic growth continues to rise in the region and fears of weakness from a U.S. slowdown dissipate.
The Bank of England surprised investors Thursday by raising interest rates by a quarter-point, to 5.25 percent, to ward off the threat of inflation amid a continued boom in the housing market and robust economic growth. The European Central Bank, at a meeting in Frankfurt, left borrowing costs at a 5- year high, but signaled it would increase rates as early as March to guard against rising prices as the European economy continued to mend.
Following a two-year slump, growth has been picking up steadily across much of the continent — although at a slower pace than in the U.K. — led by a recovery in Germany, the largest economy in the euro zone.
The British economy has moved ahead more quickly, fueled by a red-hot housing market that helped the economy expand 2.7 percent from a year earlier in the third quarter. Home prices have surged 15 percent over the past two years, according to the Halifax House Price Index, and they have not declined on a year on year basis for more than a decade.
Still, the Bank of England's decision to raise rates — bringing them to the same level as in the United States — surprised investors who believed the bank's most recent increase in November would be its last for a while.
One reason is that oil prices have been easing for the past six months from highs above $78 in July, which generally eases prices on items like airline tickets, countering inflation. British Airways said Thursday it was reducing fuel surcharges on many routes as crude oil prices hit fresh 19-month lows Thursday.
That decline has accelerated in the past two weeks after unseasonably warm temperatures cut demand. The price of a barrel of light, sweet crude oil for February delivery fell below $53 a barrel in afternoon trading Thursday in New York.
Meanwhile, the British pound has also been enjoying a bull run against the dollar, the euro and other major currencies. Traders expect the pound to top $2 by the end of the quarter.
Despite these developments, the "margin of spare capacity in the economy appears limited, adding to domestic pricing pressures," the Bank of England's monetary policy committee said Thursday. "It is likely that inflation will rise further above the target in the near term," it added.
The move alarmed businesses and some economists in Britain, who said it could harm the economy and curb spending. Many British consumers are highly leveraged, with large mortgages to pay for their homes, and big credit card debt loads, as spending is buoyed in part by property wealth.
"This is an unnecessary blow, said the British Retail Consortium director general, Kevin Hawkins, said. "The effect of the November rise has not yet worked through to household spending and, coming so soon after, another rise will hit consumers hard."
The Bank of England has "overreacted by stepping up the pace," added Holger Schmieding, an economist with Bank of America in London. The rise in British rates in November should have been sufficient to tamp down rising prices, Schmieding said.
The worst case scenario, he added, would be for the Bank of England to raise rates another quarter of a point in a few months, and "realize too late they are overdoing it."
For the euro-zone member countries — which took in Slovenia on Jan. 1 — the central bank has steadily lifted rates as rising economic growth and high oil prices fanned inflation.
The ECB on Thursday forecast the economy would expand at a respectable pace in 2007, lifted by continued recovery in Germany, where the government reported growth of 2.5 percent in 2006, more than double the rate of the previous year. For 2007, the economies of the 13 nations that share the euro are expected to expand at an average rate of about 2.6 percent, a forecast that is also aided by perceptions that the United States economy will not slow as dramatically expected this year.
Although euro-zone inflation has fallen below the bank's goal of less than 2 percent for four straight months, Jean- Claude Trichet, the president of the ECB, warned the bank would lift rates again in March if companies pass previous energy price increases through to their customers, or if the price of oil, which has retreated recently, spikes again.
"Looking ahead, acting in a firm and timely manner to ensure price stability in the medium term is warranted," Trichet said.
Most notably, Trichet gave a rare bit of explicit guidance to bond market investors who have bet heavily on another increase in March.
"I would say nothing here that would change expectations by the market that we could do something at the end of the first quarter," Trichet added. "I would not contradict that."
Trichet also emphasized the sharp rise in money supply, which grew at an annual rate of 9.3 percent in November, the highest monthly rise since the introduction of the euro in 1999.
And he all but ruled out the possibility that the increase in the German value-added tax that took place on Jan. 1 would have more than a passing effect on growth and inflation there, saying the bank's sanguine view on this matter was "well-founded."
"The only open question in my mind after listening to the ECB is to simply ask the question 'why are you waiting?'" said Thomas Mayer, chief Europe economist at Deutsche Bank in London.
Germany supports ECB
Germany said Thursday it would not tolerate any watering down of the independence of the European Central Bank, as suggested by French political leaders embroiled in a general election campaign, the Associated Press reported from Berlin.
"The ECB is independent, and nothing is going to change that," the German finance minister, Peer Steinbrück said.
Carter Dougherty reported from Frankfurt.