New inflation risk may force Bank to boost rates

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The Bank of England stoked fears that interest rates would rise sooner rather than later after it yesterday raised its inflation forecast partly to reflect the impact of the Budget.

The Bank's Monetary Policy Committee said in its quarterly Inflation Report that the risk of underlying inflation overshooting its 2.5 per cent target in two years was now 68 per cent, against its February prediction of 57 per cent. Inflation was predicted to hit 2.6 per cent in the second quarter of 2004 and while inflation was likely to sit below target until then, the risks were that the projections might rise.

Higher public spending twinned with an upturn in global demand would offset weaker consumer spending, to push annual GDP growth to 3 per cent by the end of the year, against a prediction of 2.4 per cent made in February. It will exceed 3 per cent by the end of 2003.

Gilts fell sharply amid perceptions that the report's revisions showed the MPC to be more hawkish – inclined to raise interest rates – than supposed. The committee's remit is to set interest rates at a level that will keep inflation to within 1 percentage point of 2.5 per cent.

While Mervyn King, the Deputy Governor, said interest rates would at some point have to return to a "normal" level, he warned against over-interpreting the report.

"There is enormous uncertainty here," he said. "I would caution against drawing too much from small changes in assumptions. [Setting interest rates] is a decision that you can take one month at a time."

John Butler, UK economist at HSBC, said: "Given this new set of forecasts it is odd that the MPC did not raise rates at the last meeting. This undoes all the recent MPC comments. It raises the risks rates could go up as early as June."

The Bank said the economy had troughed in the last quarter of 2001, yet it warned that there were still risks that the growth target might slip. Hard evidence of economic recovery had yet to emerge and amid the prevailing uncertainty interest rates had last week been left unchanged at the 38-year-low of 4.0 per cent.

Mr King also said that while the ratio of average earnings to property prices was not at its peak, it was prudent to "take action" before the peak was reached. "There is no doubt that these rates of [house price growth] are unsustainable. But there are many other things in the economy that are unsustainable," he said.

Earlier, official data showed unemployment rising to 3.2 per cent, with the claimant count rising by 5,400 to 953,000 in April despite predictions of a fall. Average earnings growth was also up, rising 2.9 per cent in the first quarter. Meanwhile, US industrial production registered a 0.4 per cent rise for April and business inventories fell for the 14 consecutive month.

The Bank's optimistic mood was echoed at the annual meeting in Paris of ministers of the 30 nations belonging to the Organisation for Economic Co-operation and Development, the so-called rich nation's club. The Belgian Prime Minister, Guy Verhofstadt, said: "The general feeling around the table was of a cautious optimism that in the next months and of the second part of the year we should see and feel the economic recovery."

Pedro Solbes, the European Commissioner for monetary affairs, said: "We think generally that the worst is behind us."

Paul Boateng, the financial secretary to the Treasury, refused to comment on whether he thought the Budget would lead to hikes in interest rates.