Quarter-point misses the real point

The trigger-happy Bank of England monetary policy committee has done it again. Having left base rates alone for precisely one month it has raised its base rate a quarter-point to 5.5%, the 15th time it has changed rates in its 28-month existence. The UK has created a rate-setting mechanism that is uniquely active among the world's richest economies. Moreover, the practice of moving in quarter-point slithers, rather than more decisively, removes all psychological impact.

Contrast this with the European Central Bank, also a new institution seeking to establish its credibility. It has changed rates twice since Euroland was born on January 1: it eased rates by half a point in spring when the German economy was stuttering and has now reversed that with the move back to 3%. This was backed by indications from ECB president Wim Duisenberg that this will be enough for the time being: a very different model. Like the Bank of England, the ECB is unable to please all regions. The Austrians, with almost no inflation, see the whole exercise as unnecessary, whereas Spain and Portugal are glad for the respite of fast credit expansion. The one-policy-fits-all straitjacket was always going to cause tensions. But there is also an element of showboating for domestic consumption in the public fissures within the ECB.

It is, of course, important that the UK monitors what is going on in Europe because one of the economic criteria on which the UK's entry to Euroland will be judged is similarity of economic cycles. That British and Euroland base rates are being raised on the same day does suggest that the UK and continental economies are moving in the same direction. The growth rate in Germany this year, as the expansion builds, is expected to be around 1.5 %, which will not be a dissimilar outcome to that of the UK.

There is, however, one area where there is significant disparity: the level of headline interest rates. Whereas the ECB rate is now 3%, the UK level will be 5.5%. It will be argued that is because inflation in the UK is higher than on the continent: but that is untrue. While the headline rate in Britain at 1.1% is higher than in Germany and France, it is bang on the average of Euroland rates. Similarly, it is close to average on the harmonised and underlying measures, too.

So why are people in Britain required to suffer more of the iniquity of higher interest rates than their continental counterparts? Three reasons are often quoted. The first is the state of the UK housing market. The much-quoted Halifax prices index has the UK in the midst of a boom with prices rising at an annual rate of 10.8%, and the authorities need to stamp on any suggestion of a late-1980s housing boom. What these figures disguise is a supply shortage reflected in the low turnover of properties. Moreover, the ratio of average house prices to average earnings is still relatively low.

The second area of concern is the labour market. Despite the revisions to the earnings data, Roger Bootle, an economist at Deloitte & Touche, is among those who still view the series with suspicion. It is pointed out that the earnings data run counter to CBI figures on pay settlements. Moreover, because many pay settlements are based on the headline rate of inflation, this may not yet be a serious worry.

The third argument is one of credibility. The UK had a dreadful time in the 1970s, the 1980s and the early part of this decade with its inflation rate running significantly ahead that of most G7 economies. To counter this the country has needed a new anti-inflation structure - the independent bank - and a demonstration that we can meet an inflation target over the cycle. To achieve this means having higher interest rates than our neighbours.

That is fine, but it takes no account of the other anti-inflation forces at work in the economy: the exchange rate, the discounting on the high street, the government's micro-economic reforms aimed at encouraging competition; the impact of e-commerce on cost structures (for instance, in delivery of financial services) and the pressure from the utility regulators for lower prices. The only contrary factor is higher energy prices, which is partly offset by the firmness of the pound against the dollar.

The debate on all of these issues is alive and well inside the monetary policy committee. It is divided on several issues. In headline terms the division has been procedural with some outside members demanding extra resources, a dispute which is in the process of being resolved. More intransigent, however, is the intellectual debate, with some economists (Sushil Wadhwani) arguing that the Bank models give the incorrect weight to exchange rates, others (DeAnne Julius) that they fail to recognise the structural changes in the prices mechanism. This may partly explain why the MPC has changed so often and is less confident in its decision-making and readings of the inflationary runes than are the Federal Reserve or the ECB.

The latest rise in interest rates is a mistake but this time the Bank has been fortunate. Because ECB rates have gone up more than those in London, the upward pressure on the exchange rate which has been so damaging to exporters may be less pronounced. After the flak which mortgage lenders took last time for raising home loan costs instantly, they are taking their time about it now.

But there is no doubt the rates will be raised and savers might find real returns improving. But the half-point rise in interest rates since September will not deal with the perceived house price problem. That requires a more decisive increase or fiscal intervention, which would be far more effective. Fortunately, concerns about the disruption to the financial system and liquidity by the millennium bug almost certainly mean there will be no further rate rises until February at the earliest. This may give the MPC the breathing space it needs to settle internal differences and realise that calm is a respectable state.