Rising inflation expectations limit scope for interest rate cuts

The Bank of England's feared scenario came closer yesterday when expectations of inflation rose to their highest level since 1999, limiting the scope for interest rate cuts to stimulate the economy.

The central bank's quarterly survey found that people's expectations for the rate of inflation over the next year were 3.3 per cent in February, more than a point above the current official rate and beating the previous high of 3 per cent in November.

The survey also showed people's perception of the current rate of inflation leapt to a record 3.9 per cent from 3.2 percent in November. Official figures showed consumer price inflation at 2.2 per cent in January, continuing a run of above-target rates that started in October.

Mervyn King, the Bank's Governor, has said he is prepared to let short-term spikes in food and energy prices keep inflation above the 2 per cent target as long as expectations of price rises do not become entrenched and start to shape behaviour.

The Bank's Monetary Policy Committee is trying to avoid a sharp slowdown in the economy without cutting rates so far that it unleashes inflation.

Alan Clarke, UK economist at BNP Paribas, said: "The pick-up in the series... is a particularly unhelpful outcome that will make it even harder for the MPC to step up the pace of interest rate easing in the near term.

"Presentationally, with concrete news that inflation and inflation expectations are rising, but at this stage only limited evidence that activity is suffering, it is very hard for the MPC to pick up the pace of easing."

The Bank of England reduced interest rates by a quarter point in December and again in February as it tried to ward off a sharp slowdown. The MPC kept rates on hold at 5.25 per cent this month and most economists expect the next cut to be in May.

Mr King has said 2008 is the hardest year since the Bank gained independence on monetary policy in 1997. He has warned inflation could hit 3 per cent more than once this year, triggering explanatory letters to the Chancellor.

So far, higher inflation expectations do not appear to be driving higher pay settlements. But manufacturers, retailers and service providers are raising prices where possible to maintain their margins threatened by the higher cost of raw materials. Howard Wheeldon, chief UK and European economist at Global Insight, said the Bank was "very aware the higher inflation expectations go... the greater will be the risk wages will eventually move up".