MPC split on interest rate rise

The Bank of England yesterday fuelled City expectations that the next move in interest rates will be up by warning it was in a heightened state of alert for a rise in inflation.

Despite predicting a further fall in the short term from the present level of 2.2%, the bank's nine-member monetary policy committee said its best guess was that inflation would rise above the government's 2.5% target over the next two years.

But disagreements between committee members about the scale and timing of the increase suggest the cost of borrowing may stay on hold at 5% for several months.

While the hawks see underlying inflation climbing to 2.75% by the summer of 2001, the doves believe it will hit a peak of about 2%, leaving monetary policy deadlocked.

The split in the committee was revealed by the publication of the MPC's quarterly inflation report.

Mervyn King, one of the Bank's two deputy governors, stressed that while there were divergent views about the extent to which inflation would rise the committee collectively agreed about its direction.

"The monetary policy committee will need to monitor carefully all the developments in prices and costs to judge the likely path of inflation."

Mr King dismissed suggestions that the weakness of inflation in the short term would prevent the MPC from raising interest rates.

With a time lag in interest rate decisions' effect on the economy the MPC had to be forward-looking, he said.

The report said that weak world prices and the strong pound had helped subdue inflation over the last two years but that commodity prices were now rising, and both world and UK economic growth was strengthening following last autumn's global financial crisis.

Mr King said the question facing the MPC was for how long the benign inflation picture would continue in the face of a recovery in output.

The differences in views on the committee reflected genuine uncertainties about the link between the growth of employment and output to changes in costs and prices.

Some members thought the pound would remain strong and depress the rate of price increases; others thought the currency would boost inflation by falling. Some believed cutthroat competition would further squeeze profit margins; others thought that although it was possible, it was not the most likely outcome.

"All members believe there has been a significant change in labour market behaviour over a number of years, but not all agree on its quantitative implications for earnings growth," said Mr King.

The inflation report was on the table when the MPC met last week and left interest rates unchanged.

Minutes of the discussion published next Wednesday will reveal the voting pattern. At the previous meeting in July Mr King said June's rate cut may have been a mistake - suggesting he could now be arguing for it to be reversed, said analysts.

Michael Saunders of Salomon Smith Barney Citibank said that while the report suggested the MPC thought rates would have to go up at some point it did not think they would have to rise too far.

"The report argues that if three-month rates follow the path projected by interest rate futures inflation will remain below target through the next two years," said Mr Saunders.