Bank of England plays down interest rate talk

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The Independent Online

Bank of England governor Mervyn King today played down the prospect of an imminent interest rate hike despite signalling borrowing costs would need to rise to curb inflation.

Mr King denied policymakers were paving the way for an early rate rise - but the Bank's own inflation forecast indicated at least two increases were on the way in 2011 to bring inflation to target within two years.

The report also revealed a downgrade to this year's growth forecast, although the Bank said the UK should avoid a double-dip recession.

Following publication of the report, Mr King said while it was "clear" rates will have to rise from their current historic low of 0.5% at some stage, the path of monetary policy was not a foregone conclusion.

He said: "Some people are running ahead of themselves and saying that we are pre-announcing or laying the ground for a rate rise.

"That decision has not been taken and won't be taken until we get to the next meeting, or the following meeting - it may be many quarters before we do anything."

The Bank reassured in its report that economic growth was set to resume following the shock 0.5% contraction at the end of 2010.

But its report predicted UK growth just below 2% on an annual rate for much of 2011 - weaker than the 2.5% assumed in its November forecast.

This would rise in late 2011 and pick up to around 3% in 2012 and 2013 as the recovery takes hold, the Bank added.

Today's report confirmed inflation is expected to soar close to 5% before falling to around the 2% target in 2012 - but this was based on interest rates rising in line with market expectations, starting as early as the second quarter.

The market expects rates to reach 1% by the end of the year and the report warned that if the Bank took no action, inflation would still be above target in two years' time.

Mr King said: "It is clear that at some point Bank rate will have to go up.

"Anyone making long-term financial decisions should not expect the Bank rate to be at these low levels indefinitely."

He also said the Bank would lift its base rate before unwinding its £200 billion quantitative easing (QE) programme, which was launched to boost the money supply and aid recovery.

However, he stressed the path of growth, private spending, export and investments would all have a bearing on inflation and therefore interest rates over the next two years.

Speculation of an early rate rise mounted yesterday after Mr King said in a letter to Chancellor George Osborne that inflation was likely to return to target "on the assumption that Bank rate increases in line with market expectations".

The letter was triggered after official figures revealed Consumer Prices Index (CPI) inflation leapt to 4% in January - double the Government's target.

Howard Archer, chief UK and European economist, said the cautious tone of Mr King's remarks today indicated he was not convinced rates need to rise yet.

"The interest rate outlook remains very uncertain and whether or not the Bank of England acts by May will depend on how well the economy performs over the coming weeks as the fiscal tightening really kicks in," said Mr Archer.

"We fully acknowledge that a move is highly possible by May but for the time being we are sticking with the view that the Bank of England will hold fire until the second half of the year."

Simon Hayes, economist at Barclays Capital, said he now expects the MPC to raise interest rates by 0.25% in May, August and November, taking the rate to 1.25% by the end of the year.

But he added: "Although we believe a May rate increase is a reasonable central view, uncertainty about the path of the policy rate remains unusually high. The MPC is clearly split on the need to tighten policy at this point in time."

The Bank has come under fire for failing to keep a lid on soaring inflation, with doubts over its credibility after yesterday's painful CPI data.

Questions have been raised over why the Bank decided to keep interest rates at 0.5% this month.

Facing further attacks today on its ability to control inflation, Mr King said: "Policy is not determined by the current rate of inflation. It has to be determined by a dispassionate judgment of the risks."

Asked if the MPC was committed to hitting the 2% target, Mr King replied the commitment is "iron clad" and added that "we are not in the business of making futile gestures".

The Bank's report showed that even if rates rise in line with market expectations, inflation will remain "well above" target for the next year or so and there are doubts over the timing and how far it will drop back.

It believes inflation will fall back next year, but cautioned "the timing and extent of that fall are both uncertain".

There are also downside risks to the growth outlook as government spending cuts kick in, according to the report.

It warned: "There are significant downside risks to private demand, especially household spending."