INTEREST rates were increased to 4.25 per cent last week. In a bizarre sequence of events, the Bank of England's monetary policy committee (MPC) has managed to increase rates in advance of the quarterly inflation report for the third quarter in a row.

The next issue of the inflation report is due to be published tomorrow. Given that the same rate-setting committee oversees the inflation report, it is entirely possible for them to have had a sneaky peek at the figures in advance.

The UK's inflation rate fell to 1.1 per cent in March, well below the MPC's two per cent central target. The task of the MPC is meant to be to maintain the new European Harmonised Index of Consumer Prices (HICP) between the bands of one per cent, at the lowest, and three per cent, at the highest.

In a statement accompanying the rate increase decision, the MPC acknowledged that current inflation remains towards the lower band. Like a naughty schoolboy with an appointment with the headmaster, the Governor of the Bank of England could be in trouble. If the inflation rate were to fall below one per cent, Mervin King would have to write a letter to the Chancellor of the Exchequer, Gordon Brown, explaining why the MPC had failed to keep inflation within its target range.

The MPC justified its tightening of monetary policy as a counter to inflationary pressures that will build up over the next two years if the economy continues to grow strongly. The MPC also noted that commodity prices "have risen sharply", a reference to recent gains in oil prices.

The MPC's main concern is closer to home. Consumers appear to have shrugged off the two previous rate rises, and continue to borrow heavily. The MPC members have responded to criticism to acknowledge that it is not their job to manage house prices, but that the strength of the housing market has an impact on the inflation rate.

Kevin Hawkins, director general of the British Retail Consortium, reacted angrily to the rate rise by saying: "There was no need for this rise. There is no evidence of consumer-led inflationary pressure and, therefore, no justification for a rise in interest rates to curb spending."

In the short term, the consensus is that rising house prices make consumers feel richer and more willing to spend. Doom-mongers are persuaded, however, that in the medium term, a sudden crash in the housing market could have the opposite effect, sending the economy as a whole into a slump, and making it likely the inflation rate would fall below the one per cent floor. Watch out for Mervin King stuffing books down the back of his shorts.

One conclusion that can be drawn from the fact that rate rises occur just before the quarterly inflation reports, is that irrespective of the inflation figures, the next increases will occur in August and November. This would conveniently fit in with most economists' forecasts for rates at 4.75 per cent by the end of the year.

This predictability makes plotting the short-term bond yield curve an extremely simple operation. If only the direction of the equity market could be predicted as easily. Although the interest rate rise was mostly expected, the market did not take kindly to the decision, after a very good six-week run.

For investment advice contact Anthony Platts on 01642 608855.

Published: 11/05/2004