Bank signals that interest rates may be near their peak

Interest rates may have almost peaked, the Bank of England indicated yesterday in its latest Inflation Report, which warned that consumer spending would slow as the housing market cooled.

Interest rates may have almost peaked, the Bank of England indicated yesterday in its latest Inflation Report, which warned that consumer spending would slow as the housing market cooled.

The Bank reined back its inflation forecast, saying it would remain close to the 2 per cent target it is expected to reach in two years if rates peak at the 5 per cent priced into the money markets by the end of 2005.

Mervyn King, the Bank's Governor, said there would be a "sharp slowing in house-price inflation" because the ratio of house prices to earnings is "not sustainable". He warned that any sharp slowdown would hit consumer spending more seriously than previously thought.

The report came as official figures showed the number of people claiming unemployment benefit fell to its lowest level for almost 30 years, while wage growth softened. In its quarterly Inflation Report, the Bank said economic growth would slow to about 2 per cent in two years from an expected 3.5 per cent pace this year. "Overall the risks from the housing market to GDP growth and CPI inflation are on the down side," it said.

The pound hovered near a one-month low against the dollar as economists bet against a back-to-back interest rate rise next month. Doug Godden, at the Confederation of British Industry, said: "It is reassuring that the peak in rates will probably only be slightly higher than where they are now."

The Bank's forecast was based on market rather than steady rates for the first time, implying the base rate will reach only 5.1 per cent in two years' time. Mixed signals from the housing market had prompted speculation that the interest rate, which was raised to 4.75 per cent this month, would rise again in September.

In his assessment of the past three months, the Governor said the outlook for household consumption was a "key uncertainty". He raised the spectre of weaker-than-expected consumption growth over the next 12 months and the report warned: "There is a risk that the MPC has underestimated the potential downward impact on consumption from a sharp slowing in house price inflation."

James Knightley, at ING, said: "They've changed their opinion on the housing market. They're talking about more risks to that slowing. That clearly points to the Bank thinking the consumer sector will slow further." Mr Knightley said it was possible the Bank could cut rates in the second half of next year.

The report said the rise in oil prices - US crude held strong near record highs of $44.42 a barrel yesterday - would add to cost pressures in the near term. But Mr King said it was "easy to exaggerate the impact of oil prices", noting the UK is less reliant on oil for energy.

The Office for National Statistics said the unemployment rate dropped 13,700 to 835,200 - the lowest since 1975. Headline unemployment rose by 27,000 in the three months to June, to 1.44 million. Despite the mixed picture, Malcolm Barr at JP Morgan said: "The labour market is probably tightening, despite the pick-up in the [headline] unemployment rate."

Meanwhile, two separate reports on pay in the manufacturing sector painted a mixed picture. The EEF, the manufacturers organisation, said sector pay settlements fell to 2.5 per cent for the three months to 31 July from 2.7 per cent. But an IRS Employment Review, published today, showed manufacturing pay awards rose to 3 per cent in the nine months to end-May, up from 2.75 per cent.