Bank raises spectre of fresh rate rise

Governor warns of rising inflationary pressures. Surge in bad debts a matter for borrowers

The Bank of England hinted at further increases in interest rates yesterday to combat rising inflation, and the Governor Mervyn King admitted there was a "50:50" chance he would have to write to Gordon Brown within the next six months explaining why inflation was far above the target.

The Bank's latest quarterly Inflation Report showed how soaring gas and electricity prices, coupled with higher university tuition fees, are likely to push inflation up and keep it above the 2 per cent target in the next two years.

Inflation, already at 2.5 per cent, is seen as spiking at 2.7 per cent towards the end of this year but with a high probability it could reach 3.1 per cent, which would trigger a letter to the Chancellor.

As part of the Bank's remit, the Governor must write an explanatory letter if inflation strays more than 1 percentage point above or below the target. Mr King said it was more likely than not he would be writing a letter. "Overall I would say, looking over the two-year period as a whole, it's well over 50 per cent, the probability of writing a letter," he said. "Over the next few months, going through the Christmas/turn of the year period, it's around 50:50," he added.

One of the reasons would be the 150 per cent rise in student fees, pushed through by Mr Brown, which are included in the inflation figures (the maximum tuition fee is rising from £1,175 a year to £3,000). The Governor said the impact would be to add a quarter of a percentage point to inflation by the end of the year.

Last week the Bank surprised the City by raising rates for the first time in a year to 4.75 per cent to try to keep a lid on inflation. But Mr King insisted the move was not a "complete bolt out of the blue". The Bank has been alarmed by data revisions showing the economy has far less room to grow without sparking further inflation than thought. It is now predicting stronger economic growth than in May as consumer spending has picked up after a dip in the first quarter, investment has recovered and trade is providing a boost, with the global economy growing robustly.

Economists said the latest projections pointed to at least one more rate rise, and many predict a move in November. Alan Castle at Lehman Brothers said: "All in all, the committee appears fairly keen to retain a strong bias to hike rates further."

The Bank's new forecasts showed inflation above its 2 per cent target in two years, whether rates stayed at 4.75 per cent or crept up as forecast by the City.

Mr King noted that the outlook was unusually fraught with uncertainty, pointing to the Middle East tensions which have driven oil prices to record highs. He said: "The main risks to the inflation outlook in the medium term are the degree of spare capacity in the economy and the extent to which profit margins and pay growth will recover as energy price inflation subsides."

With bankruptcies at record levels and the big banks reporting sharp rises in bad debt provisions, the Governor admitted there were "serious problems". But he said this did not affect the economy as a whole and it was a matter for the Government and the borrowers. "The vast majority of household debt, 83 per cent, is secured against housing," Mr King said. "There are no obvious signs of distress in repayments in that area."

Official figures yesterday showed Britain's trade deficit with the rest of the world narrowed in June to £6.46bn from an upwardly revised £6.98bn in May. The underlying shortfall, which excludes oil and erratic items, held steady at £6.3bn. Britain remained a net importer of oil, though the oil trade gap shrank to £58m from £290m in May.