Bank of England copies 'inflation will be temporary' pose

Section:

Bank of England Signals that Rates Will Be at 5% for Some Time

By Edmund Conway
The Telegraph, London
Wednesday, June 18, 2008

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/06/17/bcnrat...

Investors have scaled back their expectations for interest rate rises at the fastest speed in 14 years after Meryvn King indicated that borrowing costs may remain on hold for some time.

Markets are now pricing in only one rate hike before the end of the year, compared with the three borrowing cost increases they were anticipating only yesterday.

In a co-ordinated move, the world's big two central banks, the Federal Reserve and European Central Bank, also gave warning that investors were in danger of getting carried away with their expectations of higher rates.

King, the Bank of England governor, used his letter of explanation to the Chancellor to say that, although inflation had hit a 15-year high of 3.3 percent last month and would rise above 4 percent thereafter, the increases would be short-lived.

He said: "There are good reasons to expect the period of above-target inflation we are experiencing now to be temporary," adding that higher inflation was caused by the rising prices of food and energy goods generated overseas.

Significantly, when he explained the actions the Bank is taking to clamp down on prices he did not mention the prospect of a rate rise.

"When setting the Bank Rate the Committee has faced a balancing act between two risks. On the upside, the risk that above-target inflation could persist explains why the Committee has not responded more aggressively to signs that the economy is slowing [that is, cutting rates]. On the downside, the risk is that the slowdown could be so sharp that inflation did not just return to the target but was pulled below."

In response, chancellor Alistair Darling, said he agreed with Mr King's analysis, adding that the Government was working with others to try to bring oil prices down.

Although Mr King's assessment indicates that rates will not be cut for some time, it also dampened speculation that the Monetary Policy Committee would soon have to lift them in order to bring costs back under control.

Following the letter's publication, the two-year swap rate -- the wholesale cost of borrowing fixed rate money over that period -- dropped more than a quarter percentage point to just over 6.25 percent, the biggest one-day fall since 1994.

Philip Shaw, chief economist at Investec, said markets were now pricing in one rate increase by the end of the year, followed by another next year, adding that the fall in both swaps and short sterling, another money market contract, were also driven by speculators taking profits.

He said: "There has been a significant sentiment over the past few weeks that the yield curve has been too steep [in pricing in forthcoming rate increases], but stopping it has been like trying to stand in the way of a falling piano."

There were similar falls in yields internationally, after officials from both the ECB and the Fed briefed newspapers that markets may now be expecting too many rate hikes on both sides of the Atlantic.

The Office for National Statistics said the Consumer Price Index rose to 3.3 percent in May -- the highest since 1992, when Britain was ejected from the European Exchange Rate Mechanism and embarked on its campaign of targeting inflation. The rate was significantly higher than economists expected, and was lifted by surges in energy and food prices. The Retail Price Index, a broader measure of costs, rose to 4.3 percent.

In accordance with the Bank's remit, which insists that CPI inflation should not be allowed to miss the 2 percent target by more than a percentage point, Mr King published an open letter to the Chancellor, and admitted that it would be only the first in a series of such missives. He said CPI would remain above 3 percent in the coming months.

However, he said if the rate "were set to bring inflation back to the target within the next 12 months, the result would be unnecessary volatility in output and employment."

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