February 12, 2008 / 9:35 AM / 12 years ago

Benign inflation eases Bank dilemma

LONDON (Reuters) - Inflation did not rise as fast as feared in January, suggesting there is still room for the Bank of England to cut interest rates significantly this year if the economy slows sharply.

In this file photo a man poses with sterling coins in London January 16, 2007. Consumer price inflation is expected to have risen further above the Bank of England's 2 percent target in January on the back of soaring global food and energy prices and lower-than-usual post-Christmas discounting. REUTERS/Toby Melville

Most surveys this year have pointed to an ugly combination of a slowing economy and swiftly rising price pressures, helping to create what Bank Governor Mervyn King has dubbed the most challenging environment in a decade.

Britain’s central bank cut rates to 5.25 percent last week but policymakers also warned on inflation, indicating they were not about to slash rates as has happened in the United States.

“It will be some time yet before the Monetary Policy Committee’s inflation concerns evaporate,” said Jonathan Loynes, an economist at Capital Economics.

“Nonetheless, there is some encouragement here that weaker demand is doing the job of containing price pressures.”

The Office for National Statistics said on Tuesday consumer prices were 2.2 percent higher on a year ago in January, just below forecasts for a reading of 2.3 percent but still the highest since June 2007.

However, the “core” rate, which excludes oil, food, energy and tobacco, eased to the lowest rate since August 2006.

Sterling fell after the figures, which are likely to provide some relief to the MPC after data on Monday showed factory gate inflation rising at its highest rate in more than 16 years.

“This highlights very clearly to the Bank of England that, stripping out the energy-related spike, inflation is behaving very well,” said David Brown, economist at Bear Stearns.

“This should be a further vindication that the Bank can extend its easing cycle to protect growth.”

BOE REPORT LOOMS

The BoE published its quarterly inflation forecasts on Wednesday having already delivered the two rate cuts it signalled in its November forecasts.

With markets expecting as many as three more before the end of the year, economists believe the central bank will downgrade its growth forecasts but also raise the near-term inflation outlook.

There is a danger that inflation will pick up markedly next month, partly due to changes to the way the statistics office measures gas and electricity prices.

In the past, utility bill changes were phased in over four months. As from next month’s release, changes will take effect straight away, meaning stiff price hikes announced by utility providers over the last month could cause a sharp spike higher.

King has said there is a risk inflation could spike beyond 3 percent this year which would require the Bank chief to write a letter to the government explaining what the central bank will do to bring price growth down.

If prices do rise that fast, it will become increasingly difficult for the Bank to cut rates to help protect against an expected slowdown in the global economy, led by the U.S.

Policymakers may find some comfort, therefore, in figures from the British Retail Consortium which showed sales rising robustly in January.

But other sectors are faring worse.

Construction activity fell for a third month running in January, according to property services firm Savills, and the sentiment in the sector hit a near-five year low.

“We do not expect the Bank to cut interest rates again until May, unless it becomes clear that growth is slowing substantially,” said Howard Archer, economist at Global Insight.

“Further out, we still expect interest rates to fall to 4.50 percent by the end of the year as we believe that the economy will see extended below trend growth and that this will eventually contain inflation.”

Editing by Mike Peacock

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