Bank raises fears of interest rate hike

Homeowners were braced for an interest rate rise by the end of the year after the Bank of England today revealed that a key inflation target would be missed if it failed to act within a year.

The Bank said inflation would be above 2% in two years if borrowing costs remained at 4.5%. But its quarterly inflation report reined in expectations that the Bank would soon ditch its wait-and-see approach, especially after gas and electricity prices surged since February and import costs grew at their strongest level for five years.

Bank governor Mervyn King said there were many risks around the forecast for inflation, including the impact of oil prices rising above $US75 a barrel last month and whether there was any spare capacity in the economy.

Mr King said it was difficult to know precisely how the rise in prices of oil and other commodities such as metals would be passed through to consumer prices.

The Monetary Policy Committee (MPC) would be keeping a close eye on inflation expectations, which had picked up recently, Mr King said.

Although the change has been "small so far", it was important to monitor what is going on, Mr King said. "If the rise were to persist then the committee would be concerned," he added.

Although the City believed a rate hike in August alongside the next report was possible, most economists expected the next move on rates to come in November.

Malcolm Barr, of investment bank JP Morgan, said today's report was more dovish than expected. "The data will need to significantly surprise the MPC if they are to move as early as in August," he said, adding that a rate rise was likely to take place in November.

ING economist James Knightley said the likelihood of interest rates going up had increased, but a 0.25% hike could be enough to satisfy the MPC and bring inflation back on track.

Investec economist Philip Shaw said: "The Bank is uncomfortable with interest rates as low as 4.5%. It would need a run of subdued economic news over the next six months for the committee to keep rates unchanged."

John Butler, analyst at HSBC, agreed. "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," he said.

Mr King said house prices had recently risen more than the MPC had anticipated, but warned this may not carry on as prices were still "remarkably" high compared with average earnings.

The Bank said import costs were rising at their strongest rate for five years, while it noted surveys that suggested fresh recruitment drives by companies would take place in coming months.

The UK economy would continue to recover from its low point of last year as consumer spending picked up, investment recovered and trade provided a boost, the Bank predicted.

But its projections for growth were slightly weaker than in February, when the Bank last published an inflation report. It was looking for a GDP figure of about 2.5% this year and 2.9% in 2007.