Deputy governor warns of turbulence if pound falls against the euro

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A sudden collapse in the "unsustainable" strength of the pound is the key threat to the outlook for inflation and interest rates, the Bank of England warned yesterday.

Mervyn King, the deputy governor, said there would be "turbulence" ahead for the economy if the pound fell against the euro. "Such uncertainties mean it may well prove more difficult to keep inflation close to the target over the next three years than it has been over the past three," he said.

In its quarterly report, the Bank forecast inflation staying below the Government's target of 2.5 per cent before rising to that level in two years' time.

The pound fell as the City interpreted the report as pointing to less pressure for short-term rate hikes. Sterling fell more than a cent to a four-year low of 1.5216 against the dollar as traders bet on US rates overtaking those in the UK. The pound also fell against the euro, to 59.90p from 58.88p.

But the Bank said sterling's exchange rate with the euro was "not likely to be sustainable". Mr King said: "If the exchange rate were to return to a more sustainable level, then domestic demand would have to fall to prevent excess pressure on capacity and rising inflation."

The report did not include a sharp devaluation of sterling in its forecast, as the Monetary Policy Committee could not agree on the odds or size of such a fall. Mr King said. "That is the big issue - how to set monetary policy when confronted with what is probably an unsustainable exchange rate?"

The report highlighted concerns over the strength of the labour and the housing markets, domestic demand, and inflation in the services sector, currently running at 4.2 per cent.

As a result it raised its forecast for economic growth this year to 2.5-2.75 per cent from 2.5 per cent in February. This was offset by the strong pound, the impact of high street competition on prices and profit margins, and weak manufacturing output.

The report said there was a risk of higher inflation in the first year of its two-year forecast if consumer spending stayed strong.

But it said the risk in the second year was of weak global activity pushing inflation down. The key threat was a "sudden adjustment to growing imbalances between major economies, perhaps involving sharp movements of asset prices" - a slowdown in the US economy and a Wall Street crash.

Economists said the report was more doveish than expected. Jonathan Loynes, of HSBC, said: "Providing the pound does not collapse, the peak in rates should not be far away."