Bank Governor hints rate rise is on the cards

Interest rates will have to rise "at some point", the Governor of the Bank of England said yesterday, triggering a flurry in the financial markets.

Mervyn King said that it had been more than three and half years since the last rate rise, making it the longest period of monetary policy stability since the 1940s. "At some point reducing the present degree of monetary stimulus will be necessary in order to keep inflation on track to meet the target," he told business leaders in Leicester last night.

His comment came too late for the markets but Mr King had given a foretaste of his view in an interview with a local newspaper earlier in the day. He told the Nottingham Evening Post he now saw tentative signs of an upturn. "So far we have been keeping rates low to ensure there was sufficient growth in domestic demand to offset the weaker external sector," he said. "If the world economy recovers then we will not need to do that." Despite the anodyne nature of the remarks, gilt yields - a ready reckoner of markets' view on rates - jumped after the comments were published. The yield of the benchmark 10-year gilt rose as much as 2.5 basis points to 4.859 per cent, the highest level since July last year.

Michael Saunders, a European economist at Citigroup, said: "The Bank will soon feel confidence about the global improvement and the resilience of the UK economy to reverse July's 'precautionary' rate cut."

Mr King's comments came as inflation fell but stayed above the Government's target for the 11th consecutive month. The target rate eased to 2.8 per cent in September from 2.9 per cent in the previous month, and the lowest rate since the start of the year.

The fall was driven by a drop in the costs of airfares and foreign holidays. There was no year-on-year increase in holiday prices for the first time since records began 10 years ago.

For the service sector as a whole inflation slowed from 4.0 to 3.6 per cent, the lowest rate since the spring of 2001. Goods prices were boosted by the largest surge in the cost of seasonal food for two decades as record high temperatures in Europe led to shortages of many foods. Prices jumped 3.3 per cent on the month, the fastest since 1983 when they surged more than 6 per cent.

The European-style HICP rate, which the Bank will have to start targeting in December or January was unchanged at 1.4 per cent. This is below the 2.0 per cent target analysts expect Gordon Brown to unveil in his pre-Budget report later this year.

The Bank of England will today announce the first review of money market operations in seven years. Paul Tucker, its markets director, will consult institutions over ways to improve and simplify the operations to reduce overnight volatility. However, it is understood the review will not look at the degree to which cuts in the base rate are passed on by high street banks and building societies.