The Bank of England cut its inflation forecast sharply yesterday, admitting consumer spending had slowed faster than expected and paving the way for a possible cut in interest rates later this year.
Its latest quarterly forecasts trimmed the outlook for both growth and inflation compared with its report in February that had been seen as a prelude to a rate rise.
Mervyn King, the Bank's Governor, stressed the risks were balanced between faster inflation and slower growth, in comments interpreted as a signal rates are on hold for several months to come.
The Bank now forecasts inflation rising to hit the Government's 2 per cent target at the end of its two-year horizon, rather than overshooting it as it forecast three months ago.
"In February, the Monetary Policy Committee argued that the main downside risk was to the near-term strength of consumption," Mr King said. "Since then that risk appears to have crystallised. Weakness in household spending has become more marked and has persisted into this year."
He said that there had been a sharp slowdown in households' disposable income during 2004, "partly due to an increase in tax".
The slump in retail sales was "more than an erratic movement", Mr King said, adding: "Profit warnings from a number of retailers, business surveys, reports from the high street and the official data all point to an easing of consumer spending."
Mr King said there had been a particularly marked drop in sales of goods "cars to clothes" rather than in services and admitted the Bank might have been too optimistic in saying the link between house prices and retail sales had broken down.
In November it suggested the impact of housing on spending had been less than the historic pattern. But since then house prices have stagnated, equity withdrawal has dropped and retail sales have suffered their steepest falls for almost three decades.
"The slowing in house prices may have had a bigger impact than we thought," Mr King said. "Another possibility is that the impact of higher interest rates combined with higher levels of consumer debt may have been somewhat larger than we anticipated."
But he said the Bank's central forecast was for consumer spending to recover to lower levels than in previous years. He said he was confident the housing market had now "stabilised".
The Bank trimmed its GDP growth forecast by 0.1 percentage points for this year and next below the Treasury's forecasts.
But it dramatically changed its inflation forecast, pencilling in a short-term spike above the target, before it adopted a lower profile than forecast three months ago. Mr King cited a number of upside risks, including the tight labour market, a lower exchange rate, rising import prices and an increase in domestic factory prices.
Analysts agreed the Bank was at pains to signal that rates were on hold for the foreseeable future but were split over whether the next move would be up or down.
David Page, a UK economist at Investec, said: "With inflation expected to be on target in two years' time the impetus for rate hikes have clearly evaporated. This leaves the Bank in a more neutral 'wait and see' phase [but] if the downside risks begin to materialise, the MPC will be forced to consider lower interest rates."
The pound fell and prices of gilts and short sterling which move in the opposite direction to rate forecasts shot ahead as the markets priced in an evens chance of a rate cut by the end of the year.
Nick Stamenkovic, an economist at RIA Capital Markets, said the pound could fall further next week if the minutes of the May MPC meeting showed that Paul Tucker and Andrew Large, who voted for a rise in March and April, had returned to the centre. He predicted two rate cuts this year.
But Michael Saunders, a senior European economist at Citigroup, said the Bank's forecast for inflation to go through target and growth above trend was a "clear signal" it believed rates had further to rise.Reuse content