Bank to flag inflation risk

By Christina Fincher

LONDON (Reuters) - The Bank of England's quarterly inflation report on Wednesday is likely to show the economy is drifting perilously close to the rocks but there is little policymakers can do to steer it away.

Since the central bank's last forecasting round in May, the prospects for both inflation and growth have deteriorated sharply. However, the focus for analysts will be not just on how high inflation is likely to go, but also where it is likely to be in two years' time.

If the Bank is confident the slowdown will be enough to let price pressures escape the system, it will show inflation at or below the 2 percent target in two years' time assuming rates are held steady.

If its projections show inflation remaining above target, it will send a strong signal that investors have got ahead of themselves in pricing in two interest rate cuts by the end of 2009, and will put a rate rise back on the agenda.

"Our guess is that the Bank's projections will show inflation moving back to target in the medium term, but possibly with upside risks," said Philip Shaw, chief UK economist at Investec. "The Bank will probably hint that rates can come down but not yet."

POLICY DILEMMA

The combination of faltering economic growth and surging price pressures has put policymakers in a bind. The economy is crying out for rate cuts: growth has slowed to a crawl, house prices are falling even faster than during the recession of the early 1990s and consumer confidence has crumbled.

But inflation is shooting up at a record pace, arguing for tighter monetary policy. Inflation hit 4.4 percent in July, well above the 3.7 percent peak the central bank pencilled in three months ago, and more than double its target.