Inflation report puts rate cuts in doubt

The Bank of England today poured cold water on expectations of further cuts in interest rates, with inflation projected to rise above target in two years' time.

In its August inflation report, the Bank said inflation would rise above its 2% target if, as many in the City have assumed, interest rates come down again early next year.

Analysts said the report and remarks by Mervyn King, the Bank's governor, at his press conference, signalled that the Bank was in little hurry to cut rates again.

"The overall tone ... clearly indicates that the Bank is now firmly back in 'wait and see' mode, following last week's interest rate cut," said Howard Archer of the consultancy Global Insight. "It also indicates that interest rates are currently unlikely to fall markedly in this cycle."

Following the Bank's decision last week to cut borrowing costs by a quarter of a percent to 4.5%, some analysts predicted that borrowing costs could go down as low as 3.5% next year. But those assumptions have been quickly dispelled following today's report.

In his statement, Mr King said inflation - currently at 2% - had risen by around one percentage point over the past nine months, partly because of higher oil prices and partly through the pressure of demand on supply.

"Inflation will probably rise a little further in the next few months," he said. "But it is then expected to fall back as the effects of the higher level of oil prices drop out of the 12-month comparison. Further ahead, the pressure of demand on supply capacity pushes up the central projection for inflation."

Sterling hit a five-week high against the dollar and rose to a one-week peak on the euro after the inflation report, reflecting changed market assumptions of more rate cuts, which would be expected to lead to a weaker pound.

Mr King dropped a heavy hint that the markets had got ahead of themselves following last week's cut, the first in two years.

Drawing a comparison to cricket commentators who had confidently predicted an England win over Australia in the Ashes, Mr King said: "But, as we saw at Edgbaston on Sunday, nothing is that certain. So, as ever, the MPC (monetary policy committee) will play each ball on its merits and not decide in advance where interest rates will go next."

The tone of Mr King's remarks will disappoint retailers and industrialists who have been clamouring for further cuts in rates.

The British Retail Consortium yesterday reported that high street retailers suffered their worst July for a decade, although it added that the figures were not as bad as expected, given that London was bombed during the month.

In its inflation report, the Bank said so far the July attacks appeared to have had little effect on business and consumer confidence. The report provided a stronger forecast of growth than analysts had expected.

It said growth was expected to remain subdued in the near term, but then pick up as the impetus from the rise in asset prices - such as shares - worked through to consumption, investment and trade. Mr King attributed the recent stock market bounce to low interest rates and a buoyant world economy, with even the eurozone showing signs of an economic pick-up.

Global Insight said it was somewhat more pessimistic than the Bank about growth prospects.

"Therefore we still forecast another interest rate cut late this year," Mr Archer said. "Furthermore, we are currently maintaining our belief that interest rates will fall to a low of 4% in the first half of next year."