Bank of England warns of high inflation if rates are left on hold

Financial markets were last night pencilling in further increases in base rates after the Bank of England warned that inflation would breach the government's target if borrowing costs were left on hold at 6%.

There were signs at its meeting last week that the Bank's monetary policy committee was split over the need to raise rates. The City's money markets are therefore assuming the MPC will tighten monetary policy before the end of the year.

The Bank's deputy governor, Mervyn King, said that the MPC was carefully scrutinising demand and cost pressures in the economy. "In setting interest rates to keep inflation on track to meet the target, the MPC remains steady but ready," he said.

While Mr King was eager to deny any mechanical link between the Bank's inflation target and the level of interest rates, City economists said there would probably be more upward moves in the coming months.

The Bank is expecting inflation, excluding mortgage interest payments, to hit 2.7% in two years, above the 2.5% target set by the government."It is unusual, if not unprecedented, for the committee to forecast inflation above target, and not come back towards target, for the whole of the second year of the forecast," said Geoff Dicks of the Royal Bank of Scotland. The strength of sterling would determine the timing of what will probably be the last rate rise in this cycle, he said.

David Walton, chief UK economist at Goldman Sachs, said the recent rebound in sterling meant there was no immediate pressure on the Bank to move. "But we do expect the MPC to be troubled eventually by the factors it has identified. We continue to expect a 50 point rise in interest rates by next spring," he said.

The Bank's quarterly inflation report said private sector demand growth would need to slow down and that pay pressures in the tight labour market "must not intensify". The profile of inflation was slightly higher than it had been in May, with the fall in the value of sterling offsetting the easing of house price inflation and weaker earnings growth.

Mr King acknowledged that members had differed over the likely path of the exchange rate and the possible risks to the inflation forecast.

Any hopes for a cut in interest rates were dashed. "I think you would find it difficult, given this outlook for inflation, to think that the immediate outlook is one of cutting interest rates," Mr King told a press conference to launch the Bank's report.

He gave little support to the argument made by the Conservatives that the £43bn of extra spending announced by Mr Brown in last month's comprehensive spending review would increase inflationary pressure. Mr King said the projections were marginally higher than expected in the March Budget, chiefly due to past underspending.

He added that they might make "a small addition to overall demand growth".

According to the MPC there was no overall impact on the inflation project.