Britain: Brighter Prospects--and Rate-Hike Rumblings

After tugging in opposite directions in 2001, Britain's manufacturing and service sectors may soon start pulling together. That's good news for economic growth, but it could be bad for inflation and interest rates.

Last year, manufacturing output fell in each quarter, bringing the overall economy to a standstill at yearend, despite continued strength in services. But in January, production outside of technology equipment was showing signs of life.

Although overall manufacturing output fell 0.4% from December, production excluding a sharp drop in high-tech equipment jumped 0.6%. Recent surveys by the Confederation of British Industry and the Chartered Institute of Purchasing & Supply also have shown firmer readings. January exports posted the strongest growth since mid-2000, and the U.S.-led global rebound should shake some dust off tech.

Meanwhile, household spending continues to fuel activity in the huge service sector. The job market remains healthy, and government tax cuts and spending are adding stimulus. House prices, a key to the recent strength in demand, rose 16.9% in February from a year ago, the largest such increase in 13 years, and new-car registrations are at record levels.

Retail price inflation excluding mortgage interest jumped to 2.6% in January, exceeding the central bank's 2.5% target. Although the February rate slipped back to 2.2%, service inflation, about a third of the retail price index and heavily influenced by wage costs, was 4.5%--and climbing. Now, with recovery prospects brightening and with February unemployment dipping to a 26-year low, cost pressures in the service sector are sure to rise further.

As a result, the Bank of England may feel increased pressure to lift interest rates from their current stimulative level--a 38-year low of 4%--sooner rather than later. Markets are starting to move in expectation of a May rate hike. So far, however, the Bank of England's Monetary Policy Committee shows little inclination toward tighter policy.

By James C. Cooper & Kathleen Madigan

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