The Bank said in its quarterly Inflation Report that the rate cut had made economists, its industrial contacts and the financial markets more pessimistic about inflation.
Senior Bank officials believe the Government's political problems are also making the markets nervous about future anti-inflation policy. 'The credibility of the medium- term inflation target has proved fragile. If it is not restored, and people's behaviour is based on higher inflation expectations, then containing inflationary pressures will be more difficult,' the Bank said.
It said the outlook for inflation was good. But it forecast the underlying rate - excluding mortgage interest payments - would level off late next year above the Government's long-term target of 1 per cent to 2.5 per cent if interest rates did not rise. Three months ago the Bank forecast that inflation would then still be falling towards the target.
The economy appears to be growing more quickly than its long-term trend rate of about 2.25 per cent a year and the Central Statistical Office could be underestimating the recovery, according to the Bank. High street spending is likely to slow as consumers tighten their belts in response to tax increases, but company investment should pick up. The net effect may be that spending and output growth fall in the second half of this year. 'This is likely to slow recovery for a while, but not stall it,' the Bank said.
The Inflation Report reinforced the belief in the City that interest rates may have reached their trough. Another rate cut is thought unlikely unless the economy weakens dramatically. Some analysts fear rates will begin rising again by the year's end. Average earnings are growing more quickly than the Bank expected three months ago, which may show that pay negotiators are compensating in advance for an expected worsening in inflation.
The Bank is worried that expectations of higher inflation may thus be self-fulfilling. But the Treasury argued that the recent rise in earnings was largely the result of higher overtime and bonus payments.
The Bank said that recent inflation figures had been good as competition between supermarkets had helped to keep prices low. It forecast that inflation would be lower during the rest of the year than it predicted three months ago, but warned that it was slightly more pessimistic about 1995.
If interest rates remain unchanged, underlying inflation - excluding mortgage interest payments - is expected to flatten out at 3 to 3.5 per cent next year, compared with 2.4 per cent in the year to March.
The market for government bonds ('gilts') had a largely quiet day ahead of the report's release, but there were suspicions that details had been leaked before publication.
The German Bundesbank unexpectedly cut its 'repo' interest rate from 5.41 to 5.35 per cent, provoking expectations of a quarter point cut in its key discount rate today.
There is intense speculation that key US rates will be raised as much as half a point around the time the Federal Reserve's policymaking Federal Open Market Committee meets on Tuesday.
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