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THE OUTLOOK FOR INTEREST RATES

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This is likely to be difficult year for UK monetary policy, as the Bank of England seeks to restrain the economy ah...
This is likely to be difficult year for UK monetary policy, as the Bank of England seeks to restrain the economy ahead of any rise in inflation.

If the government intends to keep inflation inside the 1% to 2.5% range, monetary policy must be tightened sufficiently to ensure economic growth slows to its potential level of around 2.5%.

The monetary tightening that began last September includes two half-percentage point rises, one in September and the other in December. The Bank must judge how much higher interest rates need to go to achieve the necessary slowdown.

This is hard; post ERM monetary policy attempts pre-emptive tightening in contrasts to1980s policy, when interest rates were raised only once inflation had picked up, to be eased only as economy moved into recession.

There are three factors influencing the central bank's judgement on how much higher interest rates need to go: the underlying momentum of the economy in the absence of further monetary tightening; the amount of remaining spare capacity in the economy; and the sensitivity of the economy to interest rate changes.

The next monetary meeting to take place between Kenneth Clarke, chancellor of the exchequer, and Eddie George, governor of the Bank of England, will take place on February 2nd. By this time there will be preliminary details of GDP growth in the fourth quarter of 1994.

The two rate rises in 1994 occurred in response to full quarter GDP releases. The full release of fourth quarter GDP containing revisions, is to be published on February 21st, after the next monetary meeting. It remains to be seen whether the next rate rise will follow the pattern of the last two.

Meanwhile most observers expect a further US monetary tightening at the next Federal Open Market Committee meeting at the end of this month.

This is even more likely in the light of December's data releases which show a fall in the official unemployment rate to 5.4%, the lowest level for four years, and December's NAPM index of business activity hitting 57.8%, the 16th consecutive month of growth.

The Fed Funds rate is expected to be raised by at least 50 basis points, (a half-percent), and the general consensus index of business activity hitting 57.8%, the 16th consecutive month of growth.

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