Morning Line: Interest rates - a little pain now or a lot of pain later?

To hike or not to hike interest rates? The Bank of England’s Monetary Policy Committee is facing a difficult but vital decision over the next few months.

Raise rates too soon and too sharply and the recovery might be choked off; keep them too low for too long and we risk letting inflation take off - which in turn could mean a catastrophic forced rate hike further down the line, causing misery for millions.

Until last week the consensus view seemed to be that we would be waiting until well into 2011 for rates to rise - perhaps even until 2012.

That view was in turn based on five main factors: the continued downward pressure on prices following the recent spike in inflation, particularly from ‘spare capacity’ in the economy; the precarious state of the recovery; difficult economic headwinds blowing in from overseas; continuing stresses within the banking sector; and the expected fiscal tightening by the new UK government.

But over the past week or so signs have started to emerge that Bank of England policymakers are questioning some or all of these assumptions, and that the consensus within the MPC over keeping rates at an historic low may finally be about to break down.

The most obvious signs of dissent have come from external MPC member Andrew Sentance, who has some for months now been the most vocal in his warnings about the dangers of keeping rates too low.

Last week it transpired that Sentance had broken ranks with his colleagues and voted for a 0.25% increase at the MPC’s June meeting. Yesterday, meanwhile, he gave an interview with Reuters which further pushed the case for an immediate increase in Bank Rate - despite the most severe austerity budget in nearly 30 years.

‘I don’t think it [the Budget] changes my view, partly because the tightening put forward in the budget is not far off expectations before the budget,’ Sentance told Reuters.

‘No one single factor should drive monetary policy,’ he said. ‘So when we look at fiscal policy, yes that’s in the mix, when we look at the euro area, that’s in the mix. But there are other factors - the state of domestic demand, the state of inflation expectations.’

‘Each member of the MPC clearly is judging that on their own account. I have come to the decision that we should begin to gradually withdraw some of the monetary stimulus.’

The key question is whether Sentance’s is a lone voice that can be largely disregarded - much as Professor David Blanchflower’s was for much of 2007 and 2008 - or whether he represents a deeper split within the eight-person MPC.

The minutes from the most recent MPC meeting are inconclusive. On the one hand the remaining seven MPC members ultimately voted to keep the status quo, suggesting that rates will remain on hold for now.