Bank warns of further rate rise to check inflation

Minutes reveal first split in ranks of MPC

The Bank of England sprang a nasty shock on home buyers and the financial markets yesterday when it warned it would probably have to increase interest rates again to keep inflation on target.

Mervyn King, Deputy Governor, said monetary policy was more finely balanced now than at any time in the past five years. But he added: "The chances are we will need a further rise in interest rates."

Minutes of the January meeting of the Monetary Policy Committee (MPC) showed that it had been split for the first time on the decision to leave the cost of borrowing unchanged, with three out of the eight members favouring an immediate increase. Given the analysis in yesterday's report, the vote was almost certainly split again at the meeting earlier this month.

The four internal Bank of England members of the MPC were, surprisingly, in the majority in favour of no change, along with DeAnne Julius, formerly an economist in industry. Mr King cautioned against over-dramatising the split, saying: "When policy is broadly on track there are likely to be small differences of opinion." Individual members of the MPC will give evidence of their views to MPs next week.

The unexpected hawkishness of the Inflation Report, which for the first time showed inflation would most likely be above its 2.5 per cent target in 18 months' time, outweighed encouraging news yesterday on earnings and unemployment.

The number of unemployment benefit claimants fell by 12,300 in January to just under 1.4 million, the lowest since July 1980. This was a smaller fall than in recent months.

Meanwhile, the growth of underlying average earnings stayed unchanged at 4.75 per cent in December, rather than increasing as expected. Employment in manufacturing fell by 17,000 during the same month.

Even so, the Inflation Report - which reflects the consensus view amongst MPC members - pointed to accelerating pay growth as one of the main inflationary dangers. "Earnings growth, especially in the private sector, will have to fall back if the inflation target is to be met," Mr King said.

"We will probably get the interest rate increase within the next couple of months," said Ken Wattret, an economist at Paribas.

Yet some City experts stuck to their view that rates have already reached their peak. They were puzzled that the Inflation Report took such a tough line, given that the MPC did not raise the cost of borrowing after its meeting last week.

But Mr King said the reason for not acting immediately was the great uncertainty about prospects for the economy. "It would not be an attractive proposition to raise rates now and have to cut them again in short order," he said.

Both business and union voices urged the Bank not to tighten policy any further at all, pointing to the fact that the pound leapt three pfennigs to DM2.97 yesterday after the Bank's comments.

Ian Peters, deputy director general of the British Chambers of Commerce, said: "They are being understandably cautious, but our view is that there is no need to put rates up again." The Bank's statement had put unhelpful upward pressure on the pound, he said.

And John Monks, general secretary of the Trades Union Congress, expressed concern about the impact of the high pound and predicted that unemployment would be rising by the end of the year.

The Inflation Report said monetary policy was being pulled in opposite directions. On the one hand, despite the strong pound, inflation had only just reached its target, and earnings growth was climbing. On the other, the economy was starting to slow.

"The question is whether the timing and magnitude of the slowdown will be sufficient to prevent inflation turning up," the report said.

The report concluded that it probably would not. The inflation forecast was less optimistic than in November's report, with the MPC expecting it to lie above the 2.5 per cent target two years from now, and warned that "the balance of risks was on the upside".

The reason for the slightly gloomier prediction was because inflation had been higher than the Bank had expected since November. The strong exchange rate had put less downward pressure on retail prices so far than the Bank's economists had expected.

Tuesday's good news about inflation last month was not a surprise and would not have changed the forecast, Mr King said.

The report concluded that the Asian crisis was unlikely to have a big impact on the British economy, partly because lower interest rates in the US, Germany and Japan would offset the world slowdown to some degree.