Bank forecasts two years of steady growth with inflation hitting target

INFLATION WILL fall further owing to the strong pound and more intense competition, before rising to the 2.5 per cent target level in two years' time, according to new Bank of England forecasts.

The Bank's Inflation Report yesterday predicted steady growth, in line with the forecasts in the Chancellor's pre-Budget statement. However, the Bank's Monetary Policy Committee remained divided on inflation prospects, with individual assessments of the most likely rate ranging from 2 to 3 per cent.

For the first time the central inflation forecast incorporated assumptions about the outlook for the exchange rate and the impact of increased high- street competition, reflecting the concerns of the MPC's doves.

Mervyn King, Deputy Bank Governor, accepted that the row over research support for external MPC members had been "damaging", but said it had not affected interest-rate decisions and was close to a solution. "I am convinced that, with goodwill, very shortly we will reach an agreement on this," he said.

"With recent growth surprisingly strong and recent inflation surprisingly low, and with unemployment at its lowest level for 20 years, there are surely grounds for optimism," Mr King said. He said the two recent rate rises would sustain growth by controlling inflationary pressures two years from now.

Robert Barrie, UK economist at CSFB, said the report was very encouraging. "It raises the hope that interest rates will not have to get as high as 6 per cent." The MPC raised rates by a quarter-point to 5.5 per cent last week, following a quarter-point increase in September.

Mr King said there was a greater than one-in-three chance that in the next 12 to 18 months inflation could fall below 1.5 per cent - the level that would force Eddie George, Bank Governor, to write a letter of explanation to the Chancellor.

The lower inflation forecast takes account of reductions in water and electricity prices, which in the short term mask pressure from rising commodity prices, faster earnings growth and strong consumer demand. The report noted that growth has been much stronger than expected, with consumer spending growing buoyantly.

The forecast has altered the assumption made about the exchange rate, taking the average of the levels implied by a constant exchange rate on the one hand and, on the other, the previous convention that sterling will fall in line with interest-rate differentials. This knocked 0.3 of a point off the central inflation forecast, compared with the old assumption, for the end of 2000.

Intensifying retail competition also contributes to the bright inflation outlook. It was assumed to take 0.2 points off inflation in each year, and the Bank will keep the impact under review.

The MPC's nine members were unable to agree on inflation and growth prospects. The Inflation Report publishes a table showing the extent to which their different views would alter the central forecast. Mr King said all had agreed that inflation would fall before picking up strongly later.

Mr King explained there had been difficulties when individual MPC members wanted to commission research not seen as a priority by other members, saying there was a need to provide extra support for personal research. "That concern needs to be catered for," he said.

Outlook, page 21