Rate rise fears ease as prices stabilise

Prospects of sharp increases in interest rates over the coming months receded last night after the City saw a reassuring health check on inflation from the Bank of England as evidence that borrowing costs were close to their peak.

Fears that the Bank would need to push interest rates up from 4.75% to at least 5.5% were dispelled when it said there were signs of the housing market cooling in response to the progressive tightening of policy since last November.

With figures yesterday showing a rise in the government's preferred measure of unemployment, City analysts said the risks of a back-to-back increase in interest rates next month had receded.

Howard Archer, economist at Global Insight, said the Bank's quarterly inflation report was "significantly less hawkish about the inflation outlook than we expected, and a September rate hike now seems completely off the agenda.

"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."

The Bank's governor, Mervyn King, said at a press conference yesterday that there was evidence that activity and prices in the housing market were beginning to ease.

The view of the nine-strong monetary policy committee, which sets interest rates once a month, is that inflation will gradually rise towards its 2% target while growth will slow down next year.

"The committee's central view is that consumption will continue to decelerate in the wake of moderate income growth and a weaker housing market," Mr King said.

The governor added that the precise path of interest rates would depend on economic developments and that there were "significant risks" to its central forecast. It was possible, he said, that inflation might be lower as a result of supply-side improvements to the economy or a sharper than expected slowdown in the housing market.

On the other hand, the apparent lack of any spare capacity in the economy and the tightness of the labour market might result in inflation being higher than anticipated.

Data from the Office for National Statistics yesterday provided mixed messages on the state of the labour market. The number of people out of work and claiming benefit fell by 13,700 in July to 835,200, its lowest level for 29 years, leaving the unemployment rate unchanged at 2.7%.

Judged by the international yardstick of people looking for work unemployment rose by 27,000 in the three months to June.

With 26,000 people dropping out of the jobs market altogether, the labour force survey showed that employment dropped by 53,000 over the quarter.

The unemployment rate on this measure, deemed as more reliable by ministers, rose from 4.7% to 4.8%, while the employment rate for those of working age dropped by 0.3 points to 74.6%.

Average earnings, closely tracked by the Bank as a guide to inflationary pressure in the labour market, remained unchanged in the second quarter at 4.4%, or 4.2% excluding bonuses.

The ONS said job losses continued in manufacturing. Employment in factories in the three months to June stood at 3.37 million, down 102,000 on a year earlier. Higher output and fewer workers meant productivity rose by 5%.

Brendan Barber, TUC general secretary, said: "In the face of the relentless fall in manufacturing jobs, firms are driving their staff harder instead of investing in new equipment and training. This is not going to break manufacturing out of the spiral of decline."