Interest rate cut back on the agenda after Bank slashes growth forecasts

The Bank of England yesterday cut its forecasts for growth and inflation in a clear sign that interest rates are set to stay on hold for some time.

The recent slump on world stock markets threatened to "dampen the recovery at home and abroad", the Bank said in its quarterly Inflation Report. The Bank expects inflation to stay below the Government's 2.5 per cent target before hitting it at its two-year forecast horizon.

In May it showed inflation heading above target in two years' time, which was taken as a clear sign rates would rise sooner rather than later. But in a significant move that puts a rate cut back on the agenda, the deputy governor Mervyn King abandoned his May warning that the Bank stood ready to counter inflationary pressure. Yesterday he said: "The [Bank] remains ready to take whatever action is necessary, in either direction, to meet the inflation target."

It also cut its forecasts for economic growth, putting them well below the Government's projections, adding that the risks were on the downside. Mr King indicated the marked shift in attitude was driven by the 19 per cent slump in shares since May.

"That was the biggest change in either direction between quarterly reports since we began them in 1987 and you have go back to the 1970s to get a fall as large," he said. "This has been the biggest news on the quarter and the biggest impact in terms of the change to our view. In terms of the domestic economy [the news] is the change for consumption and investment."

He said some of this had been offset by house prices but went on to forecast a "marked" slowdown in the housing market.

"The sharp slowdown in house price inflation may be associated with some moderation in consumer confidence and spending growth," the report said.

The Bank forecast house price inflation would slow from its current "unsustainable" rate of 21 per cent to closer to average earnings, currently 3.8 per cent. It published figures showing a slowdown may already be under way. Over the past two years annual price inflation at the top end of the market has slowed from 20 per cent to 3 per cent but has been masked by a similar rise among homes at the bottom end.

Overall Mr King said there were "enormous uncertainties" over the forecasts and acknowledged fears of a "double dip" recession in the US.

"The Bank was particularly concerned that there was uncertainty about how consumption and investment would react to the falls in equity prices," he said.

Charlie Bean, the Bank's chief economist, hinted at a possible rate cut, saying the "bulk" of the impact of last year's loosening had already passed into the economy.

However, Mr King appeared to close the door to an imminent cut, saying the risks to inflation two years out were on the upside. He put the blame at the door of the Treasury, saying the Budget decision to increase national insurance would hike business costs while public spending measures "posed upside risks to growth and inflation".

The report also showed the MPC believed there was a greater chance of overshooting rather than undershooting the target. Mr King played down the importance of June's surprise slump in manufacturing, which the MPC did not know when it left rates on hold last week. "There may be a bounce back but we simply don't know," he said. "Only when data for July and August are available will it be possible to see how far the underlying level of output has been affected."

Economists in the City were agreed that the Bank was in no hurry to raise interest rates. "This is as explicit as the Bank gets in signaling a neutral bias," said Danny Gabay at JP Morgan.