Bank cools rate hike fever

LONDON (Reuters) - Inflation rose in May to its highest since the Labour government took power in 1997, but expectations of higher interest rates ahead fell sharply because the Bank of England said the rate outlook was uncertain.

The Office for National Statistics said on Tuesday consumer prices rose 0.6 percent last month, taking the annual rate up to 3.3 percent from 3.0 percent in April -- higher than forecasts for an inflation rate of 3.2 percent.

The rise above 3.0 percent meant BoE Governor Mervyn King had to write an open letter to the government explaining how the central bank would bring inflation back to its 2 percent target.

He pointed the finger of blame at soaring fuel and food prices and said inflation could even top 4 percent this year, but argued the spike would be temporary.

Policymakers had to balance short-term price pressures against the risk that sharply slowing growth meant inflation could be below 2 percent in two years' time, he said.

Markets took that as a dovish signal, swiftly pricing out one of the two rate hikes that investors had been betting on beforehand.

In recent weeks, inflation worries have smothered any concerns among investors about the impact of the credit crunch on growth, but many economists have maintained throughout that it is unlikely British interest rates are about to rise.

"King blamed most of the rise in inflation on global issues," said Paul Dales, an economist at Capital Economics.

"Our sense is that this means interest rates are likely to stay on hold for now. The Bank does not seem in a rush to move in either direction."

GLOBAL PROBLEM

Policymakers around the world are facing rising commodity prices just as economies are slowing in the wake of the credit crisis -- a dilemma King has dubbed the toughest challenge since the BoE was given control of interest rate policy 11 years ago.

The European Central Bank has signalled it could raise rates as soon as next month and investors had also started to price in a more hawkish approach from the U.S. Federal Reserve.

However, those central banks also dampened rate hike expectations on Tuesday, helping to fuel a rally in financial markets.

Rising living costs and a weaker economy have also combined at a tough time for out-of-favour Prime Minister Gordon Brown who faces a real risk of losing power to the Conservatives at the next election due by May 2010.

Chancellor Alistair Darling said it was vital for countries around the world to act together to bring down oil and food prices in order to cool inflation.

The May inflation data showed food and non-alcoholic beverages added 0.14 percentage points to May's annual rate -- the largest contribution. Housing and household services added 0.09 percentage points as utility bills rose.

"Everything looks strong: services, goods, food, utilities. (This) highlights the severity of inflation pressures hitting the UK," said Michael Saunders, economist at Citi.

Under the BoE's remit, King has to write an open letter to the government if inflation deviates more than one percentage point away from the official two percent target.

This has only happened once before -- last April -- since the BoE was granted independence when Labour came to power.

Markets will now await minutes from the BoE's June interest rate meeting and a speech from King on Wednesday for further insight into where borrowing costs may be headed.

"The letter is by no means the whole story," said Malcolm Barr, an economist at JP Morgan.