January 13, 2011 / 4:08 PM / 9 years ago

Bank keeps rates low as inflation spike looms

LONDON (Reuters) - The Bank of England kept its key interest rate at a record low on Thursday, judging that longer-term downward pressure on prices from a slowing recovery will ultimately quell a looming spike in inflation.

Consumer price inflation was 3.3 percent in November and is forecast to rise to 4 percent in the coming months due to higher food and fuel costs and last week’s rise in sales tax — putting the central bank under some pressure to raise rates.

But the Bank expects that by early next year inflation will fall back to its 2 percent target, which it has exceeded since December 2009. The economic recovery is still seen as too weak for this extended period of above-target inflation to trigger a longer-term spiral in wages and prices.

“Inflation is primarily being driven by temporary factors such as a rise in VAT, high commodity prices and past depreciation of sterling. Stripping away these factors reveals that underlying price pressures remain low,” said Nida Ali, economic advisor to accountants Ernst & Young.

Economists polled by Reuters last week were unanimous in the view that the Bank would keep its interest rates on hold this month and make no change to the 200 billion pounds of quantitative easing asset purchases conducted from March 2009 to February 2010.

There was no significant market reaction to the decision.

However, financial markets are now pricing in a strong chance of an interest rate hike as early as May, as they predict the Bank will be forced to take action to defend its credibility in the face of rising public inflation expectations.

“Pressure is mounting on the MPC,” said Roger Bootle, economic advisor to Deloitte. “However, I continue to think that the rise in inflation will be temporary and believe that interest rates need to stay low if the economy is to stand any chance of weathering the enormous fiscal tightening.”

The Coalition aims to reduce the country’s budget deficit to 1 percent of GDP by the 2015/16 tax year, down from 10 percent in 2009/10.

MAY MOVE?

While economists polled last week on average did not expect the Bank to raise rates before November, traders in interest rate futures think a move could come as much as six months earlier.

The main reason for the change in market sentiment has been surveys showing inflation expectations among the general public — which may drive wage demands — rising to a two-and-a-half year high, as well as rising inflation expectations among bond investors. Short-dated gilt yields have also risen in anticipation of an interest rate rise.

RBC interest rate strategist Sam Hill estimated that UK markets had priced in an extra 1 percentage point of Bank tightening for 2011 compared to what they saw in late October, when more QE was still seen as a realistic possibility.

The exact considerations dominating the MPC’s discussions on Wednesday and Thursday will not become clear until January 26, when the Bank publishes minutes of the meeting. Most economists expect a repeat of the three way split that has been in place since October.

MPC member Andrew Sentance has called for a rate rise since June, now that the economy is no longer in recession, while his colleague Adam Posen believes more quantitative easing is needed due to a lack of bank lending to support the recovery.

The other 7 members of the MPC have voted to keep policy unchanged.

The Bank faces a high degree of economic uncertainty at the moment. The coldest December in 100 years has made it hard to judge the underlying rate at which the economic recovery is losing pace.

While Britain’s small manufacturing sector is getting a strong boost from exports, the domestically focussed services sector is suffering from weak demand due to high household debt levels and the looming government spending cuts.

Additional reporting by Fiona Shaikh and Christina Fincher; Editing by Hugh Lawson

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