Bank forecasts short-term rise in inflation

Inflation is likely to rise in the short term, the Bank of England said today, setting the stage for an interest rate increase.

In its latest quarterly inflation report, the Bank said that inflation (currently at 1.8%) was expected to rise from the impact of higher energy prices and import costs, before falling back to a point close to its 2% target.

"The latest increases in energy prices are likely to push inflation back above the target in the short term," the report said. "The extent to which the presently subdued rate of inflation in the non-energy components of CPI [consumer price inflation] will persist once the temporary influence from higher energy prices abates remains a source of considerable uncertainty."

The Bank also said GDP growth was likely to stay close to its long-run average over the next three years, on the back of a steady rise in consumer spending.

The Bank's monetary policy committee last week left interest rates unchanged at 4.5% for the ninth month running, amid expectations that there will be no further cuts to the rate this year.

If further cuts are off the table, the Bank also seemed in no hurry to raise rates, saying the risks to the inflation outlook were balanced. In the report's opening statement, the Bank governor, Mervyn King, cited the risks of an inflation increase from higher oil and other commodity prices.

But he also cited uncertainty about the speed and extent of any fall in inflation once energy prices stabilised.

David Brown, of Bear Stearns International, told Reuters: "While there is no argument for lower rates in the Bank of England's book, equally benign UK inflation effectively rules out a UK rate hike for a considerable period."

Analysts who had been expecting another cut to follow the reduction last August have had to revise their expectations. While consumer spending remains restrained, there are signs that the long-awaited rebalancing of the British economy is finally taking place.

House prices are also picking up, giving the Bank another incentive not to cut rates. Moreover, the long-suffering manufacturing sector is showing signs of revival and exports are picking up on the back of a recovery in the eurozone.

Figures released today by the Office for National Statistics (ONS) showed a much smaller trade gap than expected.

The trade deficit fell sharply in March after goods exports outstripped goods imports, the ONS reported. The goods trade deficit shrank to £5.45bn from £7.04bn in February.

The question in the City now is not whether the Bank will raise rates, but when and by how much. Some analysts expect borrowing costs to rise by 25 basis points this year and again next year, increasing rates to 5.25%. But John Butler, of HSBC, believes the market has "got ahead of itself".

Mr Butler said: "In the near term you require either big upside risks to GDP growth, a sharp rise in wage growth or even further strength in global demand to justify an early rate hike."

For his part, Mr King said: "No one knows where interest rates are going ... It's a mistake to try and get into this business of nods and winks [about] interest rates. Some changes may seem more likely than others. What we're trying to do is keep it very simple."