Inflation fears as jobless rate falls to 17-year low

Interest rates have paused but not yet peaked, economists predicted yesterday as the Bank of England admitted there was still a risk that it would overshoot its inflation target two years from now. That fear increased yesterday after a sharp fall in the jobless rate to its lowest level for 17 years.

The City's caution, which led to a 72.2-point drop in share prices, came despite labour market data suggesting the economy had entered a golden period where inflation and earnings growth remained stable despite strong economic growth and a falling unemployment rate.

In its Quarterly Inflation Report, its first since being set free to determine monetary policy, the Bank of England said the cost of living would fall over the next year but admitted it would be on a rising trend at the end of its two-year forecasting horizon.

Mervyn King, the Bank's economics director and a deputy-governor designate, said there was a greater probability that inflation would be higher than its 2.5 per cent target than lower on the basis of current rates.

But the Inflation Report restated the Bank's belief that monetary policy had reached a position where it could stand back for a while to "assess the direction in which the inflation risks are likely to materialise".

The inflationary risks from the consumer boom were underlined by official figures earlier this week showing a rise in the headline rate of inflation to 3.3 per cent, although the rise was driven by higher mortgage rates and excise duty increases in the Budget. Excluding those factors, the underlying rise in the cost of living was static.

The argument that the British economy was enjoying a virtuous cycle of strong growth coupled with low inflation was boosted by labour market figures yesterday showing an unexpectedly large fall in the jobless rate but flat earnings growth. Just under 50,000 returned to the workforce in July, taking the unemployment rate to 1.55 million, its lowest level for almost 17 years.

The fall in the unemployment rate took the percentage of the workforce without a job to 5.5 per cent, down from 5.7 per cent in June. That was the lowest percentage since April 1990.

David Coleman, an economist at CIBC Wood Gundy, said: "Although there may be some uncertainty about the seasonal adjustment, a monthly fall in unemployment of almost 50,000 is impressive by any standards. There is still reason to be cautious, however. Some slowing in the pace of fall in unemployment will be needed if the risk of bottlenecks and skill shortages is to be avoided."

Despite that concern, wage pressures showed no signs of increasing last month, with average earnings growth holding steady at 4.25 per cent. Economists said the figures added weight to the idea - increasingly fashionable in the US - that structural changes in the labour market over the past decade had significantly reduced the rate of unemployment consistent with a take- off in wage growth.

Jonathan Loynes, UK economist at HSBC Markets, said: "These figures provide a further hint that the UK is enjoying a US-style combination of strong activity, low unemployment, and subdued wages growth."

He warned, however, that the Bank's monetary policy committee would remain concerned that unemployment could not continue to fall at the current rate without wage pressures eventually emerging.

Another analyst said: "The key point the Bank made when it raised interest rates after the last meeting was that a peak had been reached. The market knows now that interest rates have not reached a peak."

Mr King said it was difficult to know how long the pause in interest rate movements would be. "I cannot anticipate how long the pause will be."

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