Bank says inflation is bang on target

The Bank of England yesterday moved to dampen speculation that it was going to follow up last week's interest rate cut with further reductions in the next few months.

Releasing its latest quarterly inflation report, the Bank's monetary policy committee raised its forecast for economic growth next year and forecast that inflation would be bang on its government-set target of 2% in two years, although it acknowledged that there were "downside risks" to that forecast.

Financial markets had been predicting that interest rates would be cut to 4% by the end of the year but moved swiftly yesterday in response to the Bank's signal that it had no pre-determined path for rates even though it cut them last week for the first time in two years. Alluding to the cricket Test series between England and Australia, Mervyn King, the Bank's governor, said: "As ever, the MPC will play each ball on its merits and not decide in advance where interest rates will go next."

The pound hit a five-week high against the dollar, trading above $1.79, after his remarks, and a one-week high against the euro. Government bond yields rose on the news.

Mr King said the MPC had been surprised at the extent of the economic slowdown in the second half of last year and felt the economy would probably stay subdued until the end of this year, growing about 2% this year, well below the 3%-3.5% rate that Gordon Brown predicted in his last budget.

A combination of a weaker pound and stronger stock market should boost activity - as should lower market interest rates, which allow things like fixed-rate mortgage rates to fall. Growth should then be up above 3% by 2007, higher than the MPC had predicted in its May report. The report also said that economic growth this year may not have slowed as sharply as recent revisions to official data suggest.

Mr King said the rise in oil prices to record highs would probably push inflation above its 2% target in the short term. It should then fall back next year, unless oil prices rise further, and move up to target in two years - the MPC's preferred horizon.

Oil prices remained a big concern for the MPC because of their potential impact on inflation and economic growth. He noted that inflation was still on its target in spite of oil prices having doubled since spring last year. No one was certain whether they would continue rising from the current level of about $64 a barrel or would fall back."There are clearly great uncertainties on both sides," Mr King said, but he added that the current price rise was mainly due to strong demand in the world economy rather than an interruption to supplies as had happened in 1974 and 1979.

"This is not simply a repeat of the 1970s."

Mr King denied that last week's interest rate cut, to 4.5%, was designed to reignite a consumption and debt binge that gripped the country between 1997 and 2004. "We are certainly not trying to drive consumers back into the shops." There had been little observable impact on the economy from the London bombings and attempted bombings last month. He was happy that house prices had stabilised over the past year but declined to forecast where they might go in future.

Economists said they felt the committee was too optimistic on economic growth and that interest rates could be cut again soon. "With the activity in the economy likely to remain soft while core inflation pressures are subdued, we continue to expect interest rates to fall to around 4% by the end of this year before slipping back to their 2003 low of 3.5% next year," said Jonathan Loynes of Capital Economics.