Bank reports better inflation outlook as unemployment sinks to 17-year low

The Bank of England's Inflation Report provided official confirmation yesterday that interest rates might have to rise again. Even so, the Bank has become more optimistic about the inflation outlook, writes Diane Coyle, Economics Editor.

"Caution is the appropriate policy position," Mervyn King, an executive director of the Bank, said yesterday. He warned that the economy was growing uncomfortably fast and the risk was that the Bank would have to take further steps to slow it down.

Mr King emphasised that the announcement in August of a pause in interest rates was an exception. "We are not in a pause," he said. Nor was the Bank wedded to raising rates in only quarter-point steps.

However, Mr King added that the risk of having to raise the cost of borrowing again was less than it had been. The report showed inflation at or below its 2.5 per cent target for the next two years thanks to a slowdown in growth next year.

City economists said the report was not as tough as they had expected. David Mackie, at investment bank JP Morgan, said: "The Bank of England is now less hawkish than most outside commentators."

Separately, official figures on unemployment and earnings yesterday helped ease inflationary fears. Underlying average earnings growth fell back to 4.25 per cent in September from 4.5 per cent because of a reduction in overtime in manufacturing. The fall in the number of unemployment claimants, at 9,500 in October, was the smallest for a year and a half.

For the first time the Inflation Report showed the Bank's forecasts for GDP growth as well as inflation. It thinks a sharp fall in growth next year very likely, and this explains the improved inflation outlook compared with its August report.

Even so, the range of City views about how far interest rates might climb remained as wide as ever.

John O'Sullivan at NatWest Markets said the door had been left ajar to a further small increase. But he went on: "It is difficult to see the Bank suddenly becoming very bearish and raising rates to 8 per cent by the middle of next year."

On the other hand, Kevin Gardiner at Morgan Stanley said: "The Bank is erring on the side of complacency."

Mr King said the strong pound meant there must be a danger that exports would decline sharply next year. However, so far they had remained surprisingly robust and that decline might turn out to be smaller than expected. In addition, monetary growth remained too high for comfort.But he said there had been an offsetting reduction in the danger that free building society shares would continue to boost consumer spending. The windfall effect had past its peak.

The Bank's statement about last week's quarter-point interest rate rise cited concerns about pay pressures. But yesterday's report merely said: "It is difficult to predict how much further inflation can fall before there is increased economy-wide pressure on real earnings."

Certainly, yesterday's figures indicated that point has not come yet. Despite an increase in the number of vacancies to a 24-year high, tying in with survey reports of skill shortages, earnings growth surprised many analysts by falling slightly.

The number of unemployment benefit claimants fell by 9,500 to 1,464,300, the lowest for 17 years. About 20,000 fewer school leavers left the register than normal for October, but this was the mirror of fewer being able to claim benefit during the summer.

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