Bank eases interest rate fears

The Bank of England eased fears today of a pending sharp rise in interest rates with predictions that it will hit its 2% inflation target in two years.

In its quarterly inflation report, released a week after the Bank's monetary policy committee (MPC) raised rates to 4.75%, it said that assuming rates rose in line with market expectations, inflation would ease in the near-term before rising to target at the end of two years.

"Inflation drops back in the near term and gradually increases thereafter in response to pressures on supply and moderating downward pressure from import prices, reaching the 2% target around two years ahead," the Bank predicted.

Inflation then flattens off as consumer demand slackens in the second year of its projection. Analysts interpreted the inflation report as dovish, indicating that borrowing costs will not rise by much more in the current cycle. The Bank has raised rates five times since November.

"The August quarterly inflation report is significantly less hawkish about the inflation outlook than we expected, and a September rate hike now seems completely off the agenda," said Howard Archer of Global Insight.

"Indeed, the report suggests that the Bank of England is currently happy with the market's view that interest rates are set to reach 5% by the end of this year and peak at 5.25% in 2005. However, much will clearly depend on developments in the housing market over the coming months."

On house prices - an area of particular concern for economists - the Bank said inflation appears to have peaked. It expects consumer spending to slow gradually as house price inflation slows.

Some economists, however, have questioned whether the housing market has really come off the boil. John Butler, an economist with HSBC, argues that most house price indicators showed a rise in annual inflation rates in July and that house price inflation remains at historically high levels.

The Bank acknowledged that it had doubts of its own.

"The MPC's central projection is for house price inflation to slow sharply during the forecast period - a similar profile to May - although there are great uncertainties surrounding that view," the report said.

The Bank is similarly sanguine on oil prices as they reach record levels. With forecourt prices rising above 80p a litre, it played down the impact of high oil prices on the UK economy.

"We are nowhere near the levels (in real terms) we were in the past when serious problems were caused. The impact on the UK, broadly self-sufficient in oil, is much less than on other economies which are more dependent on oil. So although we're not being complacent, its easy to exaggerate the impact of oil prices on the UK economy," said the Bank's governor, Mervyn King.