Friday, July 06, 2007

Is the U.K. rate rise wise? We surmise not.

The Bank of England raised interest rates for the fifth time in the last twelve months, raising the main interest rate by a quarter point to 5.75%. The rationale is to combat inflation which remains above their 2% target.

It is not difficult to question this move. First it appears that the basis for the move was pressure on some industrial prices, but manufacturing is not what is driving the U.K. economy. Second, the U.K.'s main rate was already higher than any of the Group of Seven industrialized nations. Third, the pound had already gained significant strength against the yen and the dollar in the last twelve months making import price pressure on inflation a complete non-issue. Fourth, the U.K. is a bifurcated economy---there are the people in the financial markets and there's everyone else. Credit card holders, homeowners and small businesses get hit with higher interest rate bills and a more stressed balance sheet. Fifth, inflation is arguably being driven by the fact that London has become a capital markets center that rivals New York and that's where fortunes are being made and spent. A quarter point rate increase will have no impact on the willingness of those in this sector to bid up home prices, to dine wherever, drive in whatever and buy whatever. It must be noted that this financial sector is the most international one in the world at this point and is the European hub for U.S. investment banks and traders, the management center for an immense amount of Middle Eastern wealth, the refuge of many capital markets, especially derivatives, innovators and traders from continental Europe who get trained at elite colleges there but move to London for the opportunities and the constructive market governance that allows innovation, and London even has the primary trading platforms of some financial concerns from countries like Japan, Australia and others. All of the participants here are simply not on the page of honoring what Governor Mervyn King of the Bank of England is trying to do.

Managing an economy with this dynamic is not a clear cut task, really hard one would think. Intelligent capital markets governance and regulation by the Bank of England is what has contributed to this problem of how to manage so much prosperity, if problem is the right word. There are no brilliant answers here but it's time for a little more creativity and patience than this latest rate rise suggests, creativity to find a solution that doesn't further divide the wealthy from the less than prosperous middle class and the patience to let the impact of the four previous rate hikes flow through the system.

Selfishly, from this perspective, the Bank of England's move puts more pressure on the dollar and more pressure on the U.S. bond market, so those Brits should take pause when taking actions that impact the consumer engine of the world's prosperity.

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