Bank could still cut rates if economy slows

Financial markets are still betting the next move in interest rates will be up but the Bank of England could be readying itself to cut rates in August in case the economy keeps slowing down.

Most economists polled by Reuters this month say that interest rates will stay on hold for the rest of the year as policymakers grapple with the highest inflation in more than a decade even though economic growth is coming to a standstill.

But when it comes to surprises, the Bank has form. Every now and again, it shocks markets by interest rate moves that almost no one has predicted - most recently its cut in December.

Policymakers are also very worried about the possibility of the economy slowing down so much that inflation is actually below the target in two years time.

"The mistake we could make, and we are all worried about this, is of holding policy too tight, and the economy weakening more than is necessary to get inflation back on target," policymaker Kate Barker said in an interview for Monday's edition of the Times newspaper.

The Bank is charged with keeping inflation at 2 percent but official figures due on Tuesday are expected to show the CPI rate hitting 3.6 percent, the highest level since the Monetary Policy Committee was set up in 1997,

But there is little policymakers can do to bring the current rate of inflation down, Bank Governor Mervyn King said on Monday in the central bank's annual report to parliament.

"The MPC can have little impact on the path of inflation in the short term. It has not attempted to prevent inflation moving away from the target following the sharp rise in commodity prices," the governor said.

"To do so would have required a large increase in interest rates with such a severe impact on output and employment that it would have risked inflation falling well below the target further out.

RECESSION WATCH

The Bank will be preparing its new quarterly forecasts as its policymakers head into their next rate-setting meeting in August - it usually likes to look out over a two-year horizon as that is how long interest rate changes take to affect the economy.

The upward march of oil prices since the May report raises the risk of much higher inflation in the short term but a lot of the activity data have been dire, leaving open the possibility of inflation undershooting the target in 2 years.

Many economists are now openly talking about recession as the housing market slide is turning out to be more pronounced than even the most pessimistic doomsayers had thought.

Figures for second quarter GDP will be out next week.

Barker told the Times she did not expect a 1990s-style recession and that there were still signs of life in retail sales. But the Bank's new forecasts will have to factor in the possibility of an even sharper slowdown in the economy.

"Clear downside risks to activity and employment" is how King characterised some of the latest news on Monday. But this, he said, had to be balanced against higher inflation becoming embedded in the system if people kept expecting prices to go up sharply.

Worrying about higher inflation expectations is one of the key reasons why the MPC stopped its rate-cutting campaign that started last December.

Policymakers gathering in May were surprised by the jump in the CPI rate to 3.0 percent in April. They could not cut rates when inflation was so clearly above the target.

But Barker pointed out that tipping the economy into recession by keeping policy too tight could also cost the MPC some credibility -- they don't want to be "inflation nutters."

One policymaker - David Blanchflower - has long been saying that worrying about inflation now is akin to fiddling when Rome burns, though his calls for cuts have fallen on deaf ears.

His colleagues will get their say this week. Andrew Sentance is speaking on Tuesday, the new chief economist, Spencer Dale, on Wednesday and deputy governor John Gieve on Friday.

The MPC makes its decision month-by-month. If the data keeps getting worse, August could be a close call.