City braces for day of the hawk

THE prospect of higher borrowing costs is looming as retail sales hit their highest level for two years and manufacturing shows signs of recovery.

And with interest-rate hawks in the ascendant for the first time in more than a year, Wednesday's meeting of the Bank of England's Monetary Policy Committee will be pivotal.

In the City last week, bank analysts warned clients that higher rates were now a real possibility. David Hillier, economist with Barclays Capital, warned: 'The next rise must be closer than we thought.' He gave odds of 4-1 against a rise this week, but shortened them to 6-4 on an increase in May.

Until last week, the City believed there was little chance of a rise until August, or even later.

Merrill Lynch economist Michael Taylor predicted rates rising by midsummer. 'The UK, which experienced less of a slowdown last year than any other major economy, has the least scope for strong non-inflationary growth,' he said.

A big shift in sentiment in the past few days has given the MPC's inflation-busters the upper hand for the first time since February last year, when the committee voted to cut rates from 6 to 5.75%.

Then, fears that the US slowdown would drag Britain into recession overcame worries about ballooning consumer credit, rising house prices and a buoyant labour market. The base rate continued to fall, especially after 11September, and now stands at 4%.

The MPC's most prominent hawk, Bank deputy governor Mervyn King, and others who feared the cuts might simply have been stoking up more trouble for the future, had to put aside their misgivings about the soaring level of personal debt and the yawning balance of payments deficit.

The priority was to keep the wheels of industry turning and the economy ticking over through the traumas of 2001. But evidence of strong consumer demand has continued to mount. Retail sales fell in in December and January but recovered to a 1.5% increase in February, which took the annual rate to a two-year high of 5.9%.

Manufacturing and engineering industries, while hardly in the best of health, have stabilised and unemployment shows little sign of worsening. Royal Bank of Scotland economist Ross Walker insisted: 'The downward momentum of interest rates has exhausted itself.' And MPC voting patterns bear this out.

At the February meeting, two prominent doves, Oxford academic Christopher Allsopp and independent economist Sushil Wadhwani, voted for a quarter-point cut. Last month the committee voted unanimously to hold the base rate at 4%.

That Allsopp and Wadhwani no longer believe a cut to be necessary suggests a big shift in mood. The MPC as a whole, measured by its voting patterns, is becoming more hawkish.

Stuart Block, economist at Schroders, forecasts a quarter-point rise to 4.25% when the MPC meets this week. 'Recent data supports the view that a rise should come sooner rather than later,' he says. 'We stick with our view that rates will move up soon and will reach 5% by the year end.'

But others are standing out against the new hawkish interest-rate consensus. Dhaval Joshi, global strategist at broker SG Securities, said: 'If you look at what is happening to earnings, which are flagging quite seriously as bonuses are cut, I should not be surprised if the next move in rates is down, not up.'

There was some support for this view last week when the March consumer confidence barometer showed a fall.