Invesco Perpetual: MPC decision to raise interest rates

In the same week that the Bank of England celebrated 10 years of independence - since taking over responsibility from the Treasury for setting interest rates - the Monetary Policy Committee (MPC) increased UK interest rates to a six-year high of 5.5%.

The statement accompanying the rate hike highlighted that business investment had been stronger than expected and the pace of expansion of the international economy remains robust. Inflation risks were said to be “tilted to the upside” in the medium term. Lower gas and electricity prices and weaker import price inflation mean that “CPI inflation is likely to fall back to around the 2% target in the course of this year”.

Consumer Price Inflation at an all-time high

The move had been widely expected since the Office for National Statistics (ONS) said that CPI inflation jumped to 3.1% year-on-year (y-o-y) in April - the highest since the series began in January 1997 – up from 2.8% y-o-y the previous month.

The increase means that CPI is now more than one percentage point above the government's 2% target, forcing the governor of the Bank of England to write a letter to the Chancellor explaining why inflation is at such a high level. Figures from the ONS also showed that the wider RPI inflation measure rose to 4.8% y-o-y, from 4.6% y-o-y the month before. This surge in inflation and strong retail sales data from the British Retail Consortium led to a number of analysts warning that rates needed to rise by 0.5%. Minutes from the quarterly meeting of the Shadow Monetary Policy Committee, held on 7 May, showed that two members voted to hold rates, three for a 0.25% rise and four members for a 0.5% rise.

US and European rates unchanged

Meanwhile, in the US, and as widely expected, the Federal Reserve unanimously decided to leave interest rates unchanged at 5.25% yesterday. The accompanying statement acknowledged the recent softer data with a shift in stance from “recent indicators have been mixed” to “economic growth slowed in the first part of this year” following initial US GDP data reporting a 1.3% annual growth rate in the first quarter, the slowest pace in four years. The statement went on to repeat its assessment that persistent inflation remains the “predominant policy concern”.

The European Central Bank (ECB) also held interest rates today, at 3.75%, with a 0.25% increase now widely expected to follow in June. Given the current wage negotiations in Germany, ECB president Trichet is expected to reinforce “significant upside risks to price stability” in the following press conference. Two-year yields are near the highest level seen in five years amidst falling bond prices. Ten-year bonds have fallen less than short-dated notes on expectations that rate increases will contain inflation.

John Greenwood, Chief Economist, AMVESCAP, stated: “Although today's 0.25% rate hike was widely expected and fully discounted, it cannot be assumed that inflation will diminish quickly or easily. Above-target inflation is becoming more entrenched. Even with sterling being strong, goods prices rose to 2.5% in March (in contrast with absolute declines experienced during the years 2000-05), while core CPI, which excludes energy and seasonal food prices, rose 2.3%. More fundamentally, double-digit money and credit growth need to be slowed to single-digit growth rates in order to be sure of returning to the 2% CPI target.”

Paul Read, co-manager of the Henley-based Invesco Perpetual Bond funds, gave the following comment in response to the increase in UK interest rates: “Today’s decision to increase interest rates comes as no surprise following the recent increase in inflation. A further 0.25% increase should not be ruled out, as this is already factored into shorter-dated bond valuations.”