Bill Jamieson: Rate rises into tumbling house prices won't go

A RAPIDLY slowing economy, a house price slump, surging oil prices – and now the worst surge in producer prices in over 20 years.

But despite the latest doom and gloom, there is not as strong a case as some are suggesting for the next move in interest rates to be up rather than down. And there is a change that can be made that would help mitigate this storm.

First, the bad news – and it is truly appalling. Output prices – the prices of goods leaving the factory gates – surged 1.6 per cent in May to hit an annual rate of 8.9 per cent – the biggest annualised gains since 1986.

Worse still was the news on input prices – fuel and raw materials bought by industry. Here prices surged by 3.8 per cent month on month in May, lifting the annual rate to a record 27.6 per cent. Input prices, according to Michael Saunders, UK economist at Citigroup, have now risen by far more in the last 16 months than the whole of the previous 21 years.

All this crushes hopes of even a modest cut in interest rates from 5 per cent to 4.75 per cent by the end of the year. The official Consumer Price Index, due out next week, is likely to show a surge well into the "letter writing" territory of 3 per cent and above. Not only does Bank of England governor Mervyn King have to explain why inflation has risen to this level, but he also has to set out (a line forgotten by many commentators) what he intends to do about it.

"Not a lot" was the consensus view until recently. Soaring fuel and food price increases were seen as a temporary blip and that there was no need to raise rates given that the economy is now slowing rapidly.

But now, with CPI inflation heading well north of 4 per cent, the Bank may be in danger of falling down in its primary duty – to fight inflation.

There is now a growing view – articulated by former MPC member Willem Buiter among others – that rates need to be raised to 5.5 per cent to counter the inflation threat. Indeed, the UK yield curve is now pricing in just such an eventuality. After all, the European Central Bank has indicated that it is prepared to raise interest rates across the eurozone. So should the UK now follow suit?

There are three big differences between the UK and the eurozone, echoing why the UK was wise not to join the euro. First, the UK economy is more dependent on the housing market, and a rise in rates at this time would, in the words of Investec economist Philip Shaw, "just about kill off the housing market, and possibly consumer spending growth as well". This risk is nowhere near as pronounced in the euro area.

Second, the MPC central projection is that inflation will fall to the 2 per cent target in two years' time (with rates steady at 5 per cent), whereas the ECB's central view is that inflation will be 2.4 per cent next year, compared with a target of "below, but close to 2 per cent".

And third, UK labour markets are less likely to attract large pay deals, suggesting lower medium-term inflation risks.

Many readers will be puzzled at why a rate rise is even in contemplation given that house prices are falling and likely to continue to do so through 2009. Some dire forecasts going the rounds spell horrendous problems for household finances, the housebuilding and construction industry and the consumer sector.

At the root of the problem is an inflation target – the CPI – which the government adopted early in its first term as a gesture of its willingness to be more compatible with the eurozone. The problem with the CPI is that it has no housing component. The result was that, in the 2002-7 period, the CPI showed inflation to be quiescent while we experienced a house price explosion. Now, with house prices falling, there is no offsetting downward pull in the CPI.

There is a powerful argument for adopting a new inflation measure which contains some element of housing costs. Unfortunately, this government, having changed the inflation measure once, cannot change it back again without opening itself to the charge of fiddling the figures to its advantage. Nevertheless, there is a powerful case to be made for an inflation measure which more accurately reflects household spending.

At present, we have a measure that is truly bringing us the worst of both worlds – low rates to fuel a house price bubble, and pressure to raise rates in a house price slump. Mad, or what?