Surprise interest rate hike to 5.25%

Based on article from The FT, 12 January 2007

The Bank of England surprised everyone with a 0.25% hike from a 5% interest rate to 5.25%. This makes it the third quarter point rise in the base rate in five months.

The rate rise was unexpected - this is the first time that the Bank of England raised rates before publishing their quarterly Inflation Report implying that this rise could be a pre-emptive strike on rising inflation.

The target measure of inflation is measured by the RPI as it is more representative of the costs of living than CPI which does not include items such as council tax, depreciation on houses and mortgage interest payments.

The Bank of England could explain the hike through high retail sales during Christmas and higer wage demands fuelled by higher costs of living. This vicious cycle of rising prices will raise wages even higher causing an increasing rate of inflation.

The rate rise means that the cost of borrowing will increase and those with a variable rate mortgage (around 7 million people) will pay an extra £14.66 a month on a £100,000 loan.

The markets reacted to the surprise as the pound soared to its highest point in terms of its trade weighted index as it reached 105.2. It also reached a 18 month high against the euro and rose more than a percent against the dollar. Appreciation of the sterling reduces import prices and thus reduces inflation.

Currently, the CPI is well above its 2% target at 2.7% and if it reaches 3% the Bank's Governor, Mervyn King will have to write a letter to the Chancellor explaining why.