'Lift rates or risk inflation target'

Quarterly bulletin: Bank concedes slowdown in the economy but says underlying prospects remain unaltered

Economics Editor

The Bank of England has again warned the Government that it will miss its inflation target unless it raises interest rates.

In its August Inflation Report, the Bank's central projection is that underlying inflation "will still be somewhat above 2.5 per cent in two years' time".

Mervyn King, the Bank's chief economist, said that if you looked at the projection, "the conclusion speaks for itself. The policy advice springs naturally from that."

Eddie George, Governor, called for base rate increases in both May and June when he met the Chancellor, Kenneth Clarke, and gave a broad hint in his evidence to the Treasury Select Committee last month that he had not given ground in his first meeting in July.

The Bank tempered its forecast from the view it took in May. Inflation would no longer peak as high in the first half of next year as it had predicted then. This was because of the slowdown in the economy so far this year and lower growth in earnings than had been expected.

However, even if the economy were to continue growing at the current rate of about 2.5 per cent for the rest of the year, the Bank made clear that it would continue to advocate higher interest rates. This suggests that the extraordinary stand-off over monetary policy since May could persist for several months.

The Bank conceded that most indicators of activity had been weak since the May report. The pattern of a "dual economy" remained marked, with those parts of the economy producing for overseas markets doing much better than those operating in domestic markets. "But the recent indicators do not alter underlying prospects for the next two years."

The dual nature of the economic recovery made the dilemma for monetary policy more acute than before. But action had to be taken before the puzzles about the strength in activity and domestic inflation were fully resolved.

"The familiar danger is that delay in taking action could ultimately result in interest rates having to go higher than would otherwise be the case."

Mr King warned of the problems of allowing inflationary expectations to rise again. Given the "huge cost" of shifting them down, "it would be a tragedy to allow expectations to rise".

The Bank conceded the slow down in activity might continue if there was destocking. "Whether this is a pause that refreshes or a pause that persists remains to be seen," Mr King said.

On balance, however, however, the Bank took a more robust view of growth prospects. In the absence of further tax increases, consumer spending should grow respectably. "It takes quite a lot to keep consumption depressed," Mr King said. The conditions were also still in place for a rise in investment. And export growth should be sustained by the depreciation in the pound.

One particular reason the Bank took this firm view was its interpretation of the labour market which has recently shown signs of weakness with the most recent Labour Force Survey showing an increase in unemployment and the rate of decline in the claimant total falling sharply.

However, the Bank pointed out that the survey had also shown a rise in employment. The activity rate - the participation of the working population in the labour force - which unusually had not recovered until this point had also risen and there had been an increase in hours worked by 2 per cent over the year.