Bank signals moderate drop in interest rates

Interest rates won't fall as sharply this year as financial markets have been predicting, the Bank of England signalled on Wednesday, although at least one more cut in borrowing costs is probably still on the cards.

The Bank's quarterly inflation report showed inflation some way above the central bank's 2 percent target in two years if rates fell as far as 4.5 percent by the end of 2008. But inflation would probably be below 2 percent if they stayed at their current 5.25 percent.

"The basic point is the Bank is saying that interest rates are not going to fall as far and as fast as markets currently seem to think," said Jonathan Loynes, chief UK economist at Capital Economics. "The indication is that it's going to proceed with bringing interest rates down at a fairly steady pace."

Sterling gained ground versus the dollar as investors cut bets on how many further cuts in borrowing costs are in the pipeline but 53 out of 54 economists polled by Reuters predicted the Bank would cut again by the middle of the year.

Financial markets had been betting the Bank would follow up last week's quarter percentage-point rate cut with three more reductions by year-end to shore up an economy buffeted by the global credit crunch.

Bank of England Governor Mervyn King said there was a possibility the economy could grind to a halt at some point at least one or two quarters this year.

INFLATION FEAR

But policymakers are also clearly worried about rising inflationary pressures due to strong food and energy prices. They see the CPI rate reaching 3 percent by the middle of this year, just shy of the level which would force Governor Mervyn King to write an explanatory letter to the government.

The Bank forecasts economic growth will slow sharply to below 2 percent by the end of 2008 from roughly 3 percent now, before recovering to around 2.5 percent at the end of its two-year forecast period.

"Both developments are now more acute than in November and as a result the near-term outlook is one of inflation rising sharply alongside a marked slowing in growth," King told a news conference presenting the report.

Risks to the growth forecast were on the downside and those to inflation were balanced.

But King was careful to ward off talk of a sharp slowdown in the economy -- a far cry from conditions in the United States where the Federal Reserve has slashed borrowing costs by 125 basis points already this year to try to stave off recession.

"There is caution and there is concern but it's certainly not this doom and gloom message that you get from people connected with financial services and property," King said. "The data so far cannot be described as doom and gloom."

There was also much discussion in the inflation report of the recent fall in sterling. The pound is 6.1 percent below its level when the last report was issued in November.

One cause for the decline, the report argued, might be Britain's large current account deficit, the largest compared with GDP in the Group of Seven industrialised nations.

"The Monetary Policy Committee attaches weight to the possibility that much of the fall in sterling reflects a more persistent decline in the real exchange rate, consistent with a rebalancing in growth away from domestic demand and towards net trade," the report said.