LONDON (Reuters) - The Bank of England raised hopes of an interest rate cut before year-end on Wednesday as it forecast the current record-breaking spike in inflation would reverse sharply as the economy grinds to a halt.
The market reaction was swift. Interest rate futures jumped more than 20 ticks and the pound fell to near two-year lows against the dollar as investors priced in an 80 percent chance of a rate cut by December and further easing after that.
The central bank’s new quarterly forecasts showed inflation — already running at more than double the 2 percent target and the highest since the series began in 1997 — would leap to around 5 percent this year.
But thereafter, it would fall dramatically as the effect of rising food and fuel prices wane and economic growth dried up.
“It may still — just — be summer, but there is a feeling of chill in the economic air,” Governor Mervyn King said at a news conference after publication of the Inflation Report.
“The next year will be a difficult one, with inflation high and output broadly flat. But with monetary policy focused on its task of bringing inflation back to the target we will come through that adjustment.”
Fears have been growing that Britain is on the brink of its first recession — two successive quarters of contraction — since the early 1990s as house prices slump and consumers spend less because rising bills have made it harder to make ends meet.
Figures out on Wednesday showed the number of people on jobless benefit rose by 20,100 in July, the biggest jump since 1992, and wages rose by the weakest rate in five years in June.
“Real wage growth is heavily negative, which coupled with the rise in unemployment will continue to constrain purchasing power,” said James Knightley, an economist at ING. “This is very worrying for consumer spending and will help to increase the probability of a technical UK recession even further.”
Under fire for its handling of the economy and desperately in need of growth-boosting rate cuts from the staunchly independent central bank, the government said it would stand by any action the Bank thought necessary.
“The government ... will continue to support the Bank’s decisions to ensure inflation comes back to target,” finance minister Alistair Darling said.
King said the road ahead would be “painful” but interest rate markets took heart from the Bank expecting inflation to undershoot the target in two years — the usual horizon it takes for monetary policy changes to affect the economy.
A Reuters poll showed expectations among City economists for lower interest rates by the end of the year were also on the rise. For story on that poll, please click on.
Before the Bank’s report, most analysts thought the central bank would hold off from cutting rates because inflation was so high. One member of the Bank’s Monetary Policy Committee, Tim Besley, even wanted to raise interest rates last month.
Minutes of last week’s meeting when interest rates were held at 5 percent for the fourth month running will not be available for another week but analysts will be focused on whether anyone will have joined MPC member David Blanchflower’s call for a cut.
“We had expected the first rate cut to come in Q1 and the risk was a pre-Christmas cut. We now think the risk scenario is the base case and the first cut comes in November,” said Alan Clarke, economist at BNP Paribas.
Some economists, however, said it would be difficult for the Bank to cut rates when inflation was so high.
“We expect easing will be mostly backloaded, probably from Q2 2009 onwards given the inflation profile, rather than imminent,” said Michael Saunders, economist at Citigroup.
“Of course, delayed easing adds to downside risks to growth, but that may well be necessary to re-anchor inflation expectations and return inflation to target.”
Additional reporting by Matt Falloon, Adrian Croft, Nigel Davies and Kate Kelland; Editing by Ron Askew