Bank faces inflation headache as growth slows

LONDON - New Bank of England economic forecasts on Wednesday will probably have a hawkish tinge despite a slowing economy, and may signal whether interest rate cuts risk drying up following some diabolical inflation data.

The Bank's crystal ball has warned policymakers for some time that they face a treacherous balancing act as inflation spirals upwards and growth cools.

Price pressures throughout the pipeline are at, or close to record levels and economic data is going from bad to worse, particularly in the housing market. The year that Bank Governor Meryvn King has called the toughest for a decade has just become a lot tougher.

Markets are jumpy and economists are finding it hard to predict when, or even if, interest rates will fall this year.

Last week, two banks switched forecasts against the tide to forecast a rate cut at the Monetary Policy Committee's May policy meeting - which never came. This week those banks are suggesting a spike in inflation to 3 percent, shown in data on Tuesday, probably rules out a reduction even next month.

Now is the time for clarity and investors hope the Bank's Inflation Report on Wednesday will give it.

"The Bank is well and truly trapped," said Alan Clarke, an economist at BNP Paribas. "The weakest ever RICS house price reading on the same day as this diabolical news on inflation means choosing the lesser of two evils.

"We will learn more tomorrow, but if MPC cuts do dry up, the UK economy will be facing a severe risk of recession."

Policymakers had seen Tuesday's surprisingly strong consumer price figures when they held interest rates steady at 5.0 percent last Thursday. But even before those numbers economists were expecting a higher BoE inflation outlook on Wednesday.

OPPOSING FORCES

The key will be how far the central bank sees inflation overshooting the 2 percent target and for how long, in the light of market expectations for interest rates. "It will be difficult for the MPC to cut rates with inflation at these levels," said David Page, an economist at Investec.

If inflation rises above 3 percent, King has to write an explanatory letter to government. This is not a backdrop against which to be trimming borrowing costs.

But pressure is growing on the central bank to lower rates and it is expected to reduce its growth outlook on Wednesday as data start to show broad weakness across the economy.

How much longer can policymakers stave off cutting rates if the downturn accelerates?

Lower growth will help to tame domestic demand and, in turn, domestic inflation, but it can do little to cool simmering external price pressures from food and fuel. If growth slows too fast, there could be bad consequences for ordinary Britons.

One Bank policymaker, arch dove David Blanchflower, has also warned that the economy could slide into recession and house prices crash by a third unless immediate, aggressive action is taken. He even thinks inflation could undershoot the 2 percent target as a result of the slowdown.

But other policymakers have been more sanguine, welcoming a slowing economy and raising the hawkish rhetoric on inflation.

The Bank has also argued, in its Financial Stability Report, that the fallout from the global credit crunch might not be anywhere near as bad as some people fear.

It is also hoped that a 50 billion pound Bank mortgage swap scheme will restore confidence, get banks lending to each other again and provide relief to homeowners facing rising mortgage costs despite three cuts in official rates since December.

So far, however, the forecasters have found it hard to predict growth or inflation with any great certainty. They hope the Bank's crystal ball is far less cloudy than their own.