Policy dilemma on interest rates

London Briefing: Tomorrow's meeting of the monetary policy committee (MPC) sees London's tribe of interest-rate forecasters split over the prospects of an immediate rise in base rates (currently at 4 per cent). While there is unanimity over the inevitability of rate rises, taking the base rate to around 5 per cent in a year's time, there is doubt over the need for an immediate move.

Where you stand in this debate is determined by the relative importance you attach to the housing market on one hand and the industrial economy on the other.

According to recent data, the housing market caught fire again during the past couple of months. The Nationwide Building Society reckons that house prices rose by 1.4 per cent in March, after rising 3.1 per cent in February. That puts prices 17 per cent higher than a year ago. The Halifax Bank said prices were up 2.2 per cent in March and are 18.5 per cent up on a year earlier.

Even long-standing bulls of property, such as myself, are beginning to grow nervous about house prices. Like the Bank of England, I thought that the interest rate rises we have seen so far would cool the rate of price increases. The opposite seems to have happened.

A friend of mine works in a job that pays slightly less than UK average earnings (just over £25,000 \ a year). He has had no trouble getting very large loans from building societies and has acquired a portfolio of buy-to-let properties.

I suspect that he may have exaggerated his earning potential to his creditors but, whatever the truth, he has ready access to seemingly abundant supplies of mortgage funds. The question is: does this story represent a modern parable of financial success or is it an old-fashioned tale of hubris and excess that can only end in disaster?

The conventional view would argue that people such as my friend have no business becoming property magnates and the burden of debt that he has assumed will be his downfall. The post-modern view, perhaps, would say the exact opposite: ordinary people have gained access to credit markets and we should not be so patronising as to assume that they, and the banks that lend to them, are being extremely foolish.

I'm not sure if anyone knows the answer but where your hunches lie will determine whether or not you think interest rates need to rise tomorrow.

Behind those house price statistics are yet more data showing continued strong borrowing by households (up by £10.7 billion in February) and mortgage borrowing up 14.5 per cent compared to 12 months ago.

The dilemma facing the MPC is that it is becoming increasingly clear that modest interest rate rises are going to do little to damp all of this exuberance. If they want to target the housing market they are going to have to up the aggression.

While the overall economy seems to be robust, manufacturing is struggling. Industrial production is less than one-fifth of the economy's total output and that share looks destined to keep on falling.

Between January and February, overall production was down 0.6 per cent. It has been falling, in absolute terms, since the end of 2000 and the absolute level of output is now lower than it was five years ago.

A combination of relentless de-industrialisation, driven by low-cost competition elsewhere, and a relatively strong exchange rate have turned the UK into an almost exclusively service-based economy. That the wider economy has continued to grow, keeping unemployment extremely low, is further testament to the remarkable economic transformation of the past few years.

It pains me to say it, but chancellor of the exchequer Gordon Brown's recent boast about Britain's economic renaissance has more than a touch of credibility to it.

Thanks in part to the MPC's policies, sterling has been rising, adding to manufacturing woes. Given the surging US economy and the dreadful problems facing Germany and Italy, the rise in the euro looks to be capped for now. Hence, further UK rate rises are only going to strengthen sterling further, adding to the problems facing the beleaguered industrial economy. The MPC's decision tomorrow will reveal much about its priorities.