Bank warns of inflation risk unless rates rise

Inflation will be above the Chancellor's target and rising by mid-1998 unless interest rates are raised, the Bank of England's Inflation Report warned yesterday.

June's quarter-point reduction in the level of base rates had worsened the inflation outlook and to have a better-than-evens chance of hitting the 2.5 per cent inflation target, Chancellor Kenneth Clarke would have to increase interest rates "at some point", the report added.

Mervyn King, the Bank's chief economist, said: "Since May there has been a good deal of evidence to suggest we can have greater confidence in the view that demand is accelerating."

According to the Bank's new forecast there is a 30 per cent chance that inflation will exceed 4 per cent by mid-1998 if interest rates are not increased in the meantime.

Mr King defended the Bank against the Chancellor's recent charge that it has a record of being unduly pessimistic about inflation prospects. It had been no worse on average than the Treasury, he said, and its inflation forecast had always been in the lowest quarter of the range.

The Bank's warning yesterday followed a recent caution from the International Monetary Fund that there was no additional scope for British interest rates to fall.

Reactions to the Bank's hawkish line were mixed. Roger Bootle, the chief economist at City investment bank HSBC Markets known for his view that inflation is dead, said: "This is the usual dose of Bank of England pessimism. I think the Chancellor will ignore them."

Businesses were unenthusiastic. Kate Barker, chief economist at the Confederation of British Industry and one of the Treasury's "wise persons", said: "There is still a lot of uncertainty about the pace of recovery. There should be no change in interest rate policy for the time being."

The British Chambers of Commerce said there was no need to increase rates though businesses would not want to see an interest rate cut that only had to be reversed.

Nationwide Building Society said it would have "some concerns" about the effect of a rise on housing market confidence. A spokesman for Abbey National, the country's second-biggest mortgage lender, said: "For the time being it would be good to see things on an even keel."

However, Martin Weale, head of the National Institute of Economic and Social Research and a Treasury adviser, said: "The Treasury is predicting bumper growth. The last base rate cut was a mistake and the sooner it goes up again the better."

Shadow Chancellor Gordon Brown claimed the Bank's report confirmed that weak investment threatened to derail the recovery. "The foundations of the British economy are not strong enough for sustained growth and rising prosperity," he said.

Many City economists also agreed with the Bank's analysis. Ciarn Barr at investment bank Deutsche Morgan Grenfell said: "It is only Ken Clarke who thinks that inflation will carry on falling right through 1997 and beyond. The Bank is taking a big gamble, but we think they are right."

David Mackie, an economist at JP Morgan said many people were underestimating the likely scale of the recovery. If only half the pounds 16bn in consumer windfalls due next year is spent, consumer spending would grow by well over 4 per cent. "The Governor should be banging the table after a couple of quarters like that," Mr Mackie said.

Yesterday's report said the inflation rate would fall below the Government's 2.5 per cent target in the short term. The accelerating pace of growth meant that two years ahead the target measure was more likely to be above 2.5 per cent and rising.

Mr King said uncertainty about the prospects for a recovery had receded since the Bank's last report in May. In particular, evidence and reports from the Bank's regional agents confirmed the view that demand was accelerating.

A separate survey from the CBI yesterday confirmed that manufacturing orders had increased in six of the 11 UK regions in the four months to July.

The Bank expects both consumer spending and investment to pick up in the year ahead. Faster growth was signalled by the rapid increase in both personal and corporate holdings of broad money.

Mr King said there was no solid evidence the economy's trend rate of growth had increased enough for the Bank to take a more relaxed view about potential inflationary pressures.