King stresses downside risk as inflation strays above target

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The Bank of England raised its forecasts for inflation and growth yesterday but moved swiftly to play down fears of an imminent rise in interest rates, saying the risks were on the downside.

The Bank of England raised its forecasts for inflation and growth yesterday but moved swiftly to play down fears of an imminent rise in interest rates, saying the risks were on the downside.

Its quarterly inflation report shows CPI inflation hitting the 2 per cent target in two years before rising to 2.3 per cent by 2008 - up from 2.1 per cent in its November report.

But Mervyn King, the Bank's Governor, said: "Overall the Monetary Policy Committee judges that the balance of risk is somewhat to the downside. The big picture has not changed a great deal [since November]."

The Governor was at pains to play down the significance of labour market figures published yesterday, which showed a fall in unemployment and a rise in underlying private sector earnings growth to 4.5 per cent - the level the Bank sees as consistent with its inflation target.

The financial markets had expected the report to be more hawkish, and the pound suffered its biggest one-day drop this year against the euro. Howard Archer, at Global Insight, said: "The Bank does not seem in any hurry to act for the time being."

Analysts said the Bank was sending a signal the next move in rates would be up, but probably not until May, when its next inflation report is due.

Unveiling the Bank's keynote quarterly forecasts, Mr King said growing demand pressures and higher import prices would push inflation "slightly above" the target two years early. He added that the "key" downside risk was that consumer spending would slow sharply, perhaps because of a steeper fall in house prices than the Bank is predicting.

The Bank forecastconsumer spending would maintain its pace of the past three years. "I think there are some downside risks to that," Mr King said. "They could come from the fact that house prices are not rising anywhere near as fast as they were ... and the fact that the actual data on consumer spending have been weaker in the fourth quarter of last year."

He played down the rise in inflation from just 1.1 per cent in September to 1.6 per cent last month, saying it had simply returned to its level in June. "These sort of movements from quarter to quarter are not things that you should attach great significance to," he said. "The short-run movements in inflation should not be given great significance."

Mr King said the biggest upside risk to inflation was that wage growth, which has stayed relatively stable despite continued falls in unemployment, would accelerate. He said the link between wages and the demand for labour had "broken down" in recent years. "It's not our central projection but there must be a risk of a pick-up in earnings growth," he said. "If demand were to go on rising at the rate it has done, at some point you would expect excess demand to push up costs and have an impact on inflation."

Figures from the Office of National Statistics showed earnings growth rose to 4.3 per cent in the three months to December, up from 4.2 per cent. Stripping out bonuses, pay growth rose to 4.5 per cent, the fastest rate since January 2002 and the level the Bank has previously said is consistent with stable inflation. Meanwhile, claimant count measure fell by 11,000 in January. Employment rose by 90,000 in the three months to December on the previous quarter to 28.5 million, the highest since comparable records began in 1971.

But Mr King played down the figures, calling the fall in unemployment "marginal" and said the increase in average earnings was "modest".

John Butler, at HSBC, said: "The next move in rates will depend on if the Bank gets greater clarity on the risks. That means what matters is whether consumer spending holds up or wage growth accelerates. The MPC seems content to wait and see and keep rates on hold."

The markets are now waiting for the official figures on January's retail sales, which are published this morning, although Mr King appeared keen to downplay their significance. "Drawing strong conclusions about spending over the Christmas period is something we should all give up for Lent," he said.

Bank observers said there was a hint of a split in the MPC, pointing to a change of language in its discussion of the views held by committee members.

Mr King said there was a "range of views" on the risks to the forecast but dropped his earlier qualification that the differences were small. Nick Stamenkovic, at RIA Capital Markets in Edinburgh, said: "I would not be surprised if one or two members voted for a rate rise." The minutes of the meeting are published next week.

The inflation report appeared to warn onrising Government spending, although the Governor refused to comment on the state of the public finances. In the report the Bank said: "Given the Government's nominal spending plans, that demand for resources is likely to grow quite quickly during the next few years."

Mr King said that the Monetary Policy Committee would make its interest rate decisions irrespective of the timing of the general election.