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Dear Gordon…

Guy Anker reports on the effects of rising inflation.

Inflation hit a 15-year high last month, prompting fears that another bank base rate rise in May is inevitable.

The consumer price index shot up to 3.1 per cent in March, up from 2.8 per cent the previous month. Many economists are predicting interest rates will have to increase from their current 5.25 per cent level by at least a quarter point next month to help bring inflation down, with the decision to be announced on May 10.

Rising interest rates could not only dampen demand but borrowers also face higher repayment charges. However, some economists think we will only see one additional rise this year.

The last time the CPI hit this level was in August 1992 when it was 3.2 per cent.

This March, the figures forced Bank of England Governor Mervyn King to write to the Chancellor for the first time since the bank was handed responsibility for monetary policy in 1997 to explain why inflation was over 1 per cent above its 2 per cent target.

King says: “Since February, sterling oil prices have risen by about 25 per cent reversing part of the fall in prices seen in the second half of last year. Higher petrol prices contributed significantly to the pick-up of inflation in March.

“Since August, the monetary policy committee has raised the bank rate by a total of 75 basis points to 5.25 per cent. At its May meeting, the committee will have an opportunity to assess more fully the news contained in the latest inflation figures before reaching its next decision. It remains determined to set interest rates at the level required to bring inflation back to the 2 per cent target.”

The news not only led to speculation about interest rates, but also saw the pound break the $2 mark for the first time since 1992. Any rate increase would be the fourth such rise since last August, when the rate was at 4.5 per cent, which had been frozen for a year.

Axa Investment Managers senior strategist Chris Iggo says: “The jump in the inflation rate virtually assures another hike in the bank rate to 5.5 per cent in May. The Bank of England has highlighted the inflation risks and implied that additional monetary tightening would be required.

“We expect just one rate hike and a shift to lower interest rates as the economy slows in 2008. The economy is likely to show signs of slowing down in response to earlier rate increases, while inflation is still likely to fall towards the 2 per cent target by the end of the year.”

Abbey chief economist Barry Naisbitt adds: “The figures on inflation were an unpleasant surprise. Financial markets have now firmed up their view of another base rate rise next month. The Bank of England’s Inflation Report next month will be critical in informing markets of the extent to which the Bank still expects inflation to fall in the second half of this year after today’s unexpected figure.”

That inflation report is due six days after the next base-rate decision, though the committee is likely to get an early look at what it contains so it can arrive at its decision.

There were forecasts of rate rises in February, March and April since the last time the rate was increased, with a jump from 5 to 5.25 per cent in January, yet the expectation was not as strong as the current round of predictions because inflation was not as high.

After that January rise, there was a stampede for fixed-rate products in between the decision on the 11th of the month and February 1 when most mortgage lenders would have raised their rates accordingly.

The sudden rush led to a number of lenders pulling their fixed-rate deals as demand was so high many ran out of funds. The increase in rates as a result was not only due to interest rate rises but swap rates – the rate at which lenders buy money from the wholesale markets – were soaring on predictions of further base-rate increases.

London & Country reveals that the money markets reacted to last week’s news by pushing swap rates up to their highest levels this year.

A number of lenders have already withdrawn their fixed rates and L&C is urging borrowers thinking of fixing their mortgage to act fast to avoid missing out on the deals currently available.

Mortgage specialist James Cotton says: “Fixed rates are proving very popular at the moment as people seek protection from rising rates. As long as people have got their fixed-rate application into the lender, that rate will be honoured, so they must not hang around.”

Another potential consequence of a rate rise could be more borrowers falling outside of prime spheres and into the sub-prime arena as they default on payments, harming their credit score.

Packager Optoma has predicted that this could mean more of a role for packagers. Sales director James Hall says: “More and more people will struggle to meet spiralling mortgage repayments. Potentially there will be an increased need for sub-prime and this could be good news for the packaging industry.

“With the huge choice of sub-prime products available, intermediaries may turn to packagers to ensure they get the most appropriate deal for their client.”

You can be sure that most eyes and ears in the mort-gage market will be firmly focused on events on May 10 to hear that all-important MPC decision.

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