Governor talks down hopes of short-term rate cuts

The governor of the Bank of England has dampened hopes of further interest rate cuts in the near term. Mervyn King last week warned that rising energy, food and import prices might push consumer price index (CPI) inflation above 3% this year, triggering a second explanatory letter to the Chancellor of the Exchequer.

Speaking at the launch of the latest quarterly Inflation Report, King said that the Bank’s central CPI projection sees inflation rising sharply from 2.2% in January before falling back towards the end of the year. However, he also spoke of a “difficult balancing act”, as the Bank attempts to control inflationary pressures while cushioning the economy from a “marked slowing in growth”.

Frances Hudson, global thematic strategist at Standard Life Investments, says King’s speech was a clear indication of a slower pace of rate cuts. She points to continued low levels of British unemployment and resilience from the housing market as significant factors.

Hudson says: “If the Bank adds a strong stimulus, such as a rate cut, it will feed inflation into the system. There is not much room for manoeuvre.”

However, she is broadly positive on the Bank’s approach and says it compares favourably with that of America’s Federal Reserve, which announced a shock one and a quarter points of cuts last month.

“The Fed cuts sent a negative message to the market,” adds Hudson. “But it will not have an effect for another six to nine months, so why do it? The market likes an orderly approach.”

While Standard Life still expects the British rate to fall to 4.5% by the end of 2008, other commentators are more cautious.

James Carrick, investment strategist at Legal & General Investment Management, says inflation will keep rising until the end of 2009. Carrick argues that because of Britain’s large current account deficit the pound will fall further, boosting import prices.

He points to data that shows sterling has fallen by 10% over the past year on a trade-weighted basis – more than at any other time since 1992.

In the medium term, Carrick says sterling needs to fall a further 20% against Asia and 10% against the euro.

“A three-quarter-point interest rate cut this year looks optimistic,” he adds.