More interest rate rises loom as the Bank lifts its inflation forecast

Interest rates may have to rise even higher than the 5 per cent the financial markets are expecting, the Bank of England indicated yesterday in its latest Inflation Report.

Interest rates may have to rise even higher than the 5 per cent the financial markets are expecting, the Bank of England indicated yesterday in its latest Inflation Report.

In one of the clearest signals from a Governor of the Bank of England, Mervyn King said the predictions of further rate rises were "not unreasonable".

The Bank raised its inflation forecast, saying it would break through the 2 per cent target if rates stayed at 4.25 per cent - and even if they reached the levels priced into the money markets.

The report came as official figures showed wage growth hit its highest level for three years, while unemployment fell to its lowest level for almost three decades. Mr King played down the inflationary threat from house prices, oil and wages in comments analysts said showed the Bank was unlikely to abandon its strategy of raising rates "gradually".

However, his comments came as crude prices hit a fresh 13-year high of $40.55 a barrel in New York as the US said supplies unexpectedly fell last week and an independent agency said demand rising at the fastest rate for 16 years.

The White House said President George Bush was "concerned" about rising petrol prices - which are becoming an increasingly important election issue. "We remain in contact with [oil] producers around the world, urging them not to act in a way that would hurt our economy or harm our consumers," a White House spokesman said.

In its quarterly Inflation Report the Bank raised its forecast to about 2.3 per cent at the end of its two-year horizon - above the Government's 2.0 per cent target and its February forecasts. The forecast showed that even if rates reach 5 per cent inflation would still bust through the target. "It does suggest the view that the market has been taking, that further interest rate rises may be needed, is not an unreasonable view," Mr King said.

The pound rose two cents against the dollar and a cent against the euro, as economists raised their interest-rate forecasts. Simon Rubinsohn, the chief economist at Gerrard stockbrokers, said: "The upbeat data, the hawkish tone of the Inflation Report and comments by Mr King leave us in no doubt that a significant tightening lies ahead."

In his assessment of the past three months, Mr King said the "main news" had been the unexpected surge in house prices over the past quarter. "It goes without saying that the committee does not target house prices inflation," he said. "But house prices do influence our judgement on the outlook for consumer spending and hence inflation - which is our target."

He expected house price inflation to slow as higher mortgage costs and lower disposable income put the brakes on the market. But he refused to rule out a crash, saying: "We don't pretend to know what the right level is."

Nick Stamenkovic, an economist at RIA in Edinburgh, said: "The question is whether the consumer will respond [to rate rises]. If not, the Bank may have to up the ante."

In one of the most detailed discussions of the housing market, Mr King said the impact of house prices on consumption depended on: how far the ratio of house prices to earnings was above a sustainable level; how fast the ratio - currently 50 per cent above its long-run trend according to Bank estimates - would return to a sustainable level; and the impact of changes in house prices on consumption.

Asked whether the Bank was now worried about the level of prices, Mr King said: "The longer the rate increases strongly the more we have to ask ourselves about the sustainability of the level." He said the small share of household income currently needed to meet mortgage payments - a reason cited by Gordon Brown why prices won't crash - would rise close to the levels of the early 1990s. But he said rates would have to reach 9 per cent before households faced the pain they endured when the market peaked in 1990.

The Governor played down the significance of official figures showing average earnings growth hit 5.2 per cent in March, the fastest rate since June 2001. They also showed the number claiming unemployment benefit fell 6,000 in April to 876,300, the lowest since August 1975. Mr King said stripping out City bonuses the growth was lower at 3.9 per cent. "The earnings numbers remain relatively moderate so I don't think it is something to regard as in any sense inconsistent with the forecast we present," he said.

He added that the level of migration into the UK raised the "tantalising prospect" that the concept of an output gap could cease to exist if every expansion in demand was matched by an immediate increase in the supply of labour.