British inflation to shoot up this year

London: British inflation will shoot up this year and stay above the central bank's target in two years if interest rates fall, according to Bank of England forecasts, leaving little scope for rate cuts to boost a slowing economy.

In its quarterly Inflation Report published yesterday, the central bank painted a bleak view of the immediate future, predicting inflation could near four per cent and the economy could even contract for a quarter or two.

"The Monetary Policy Committee is facing its most difficult challenge yet," Governor Mervyn King said. "We are travelling along a bumpy road as the economy rebalances. Monetary policy cannot, and should not try to, prevent that adjustment."

The June gilt future fell more than half a point on the worsening inflation outlook while back month interest rate futures fell sharply as dealers bet against further interest rate cuts from the Monetary Policy Committee.

"The Bank of England's May Inflation Report suggests that the MPC will not deliver the rate cuts that the news on the economy suggests are sorely needed," said Jonathan Loynes, chief European economist at Capital Economics.

Explanations

King admitted that he would probably soon have to write several letters to the government, explaining why inflation was more than a percentage point above the central bank's two per cent target - as required by the central bank's remit.

The report showed inflation at around 2.25 per cent in two years' time if interest rates fall by 50 basis points as expected by markets. It is rare for the central bank to predict such a deviation from the target over such a time frame.

Yet the BoE report also showed GDP growth slowing to around 1 per cent at the end of 2008, with an outside chance of a contraction.

Many analysts had been expecting a rate cut in June but they have been rethinking this after data this week showed high inflation.

King said policymakers needed to focus on the medium-term outlook for inflation and risks to this still lay on the upside. This was due to higher commodity prices and the risk that higher inflation rates become self-fulfilling.