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Bank of England sees inflation risks on upside

LONDON: The Bank of England said on Thursday that Britain was on course to hit the official inflation target of 2.5 percent in two years' time although the balance of risks was slightly on the upside.

In its quarterly inflation report, the central bank said it expected economic growth to rise towards 3.0 percent before easing to a little below 2.5 percent for most of the forecast period, near trend.

Its growth expectations are slightly softer than those in the November report because of the higher exchange rate and higher official interest rates.

The central bank raised interest rates in January and February taking the key repo rate to 6.0 percent.

"The balance of risks to inflation is judged to be slightly on the upside; the risks to output growth are thought to be broadly balanced," the inflation report said.

The bank said the principle upward pressures on inflation were the higher path for nominal earnings growth and stronger determinants of consumer demand. The stronger pound and higher interest rates were exerting downward pressure.

"The most likely outcome is for inflation to decline to around 2.0 percent during this year, and then to rise to around the 2.5 percent target in the second year of the projection.

The bank said that sterling had risen further since the autumn, particularly against the euro, and that the level of the exchange rate could not readily be explained by recent news about the relative positions of the economies concerned in the economic cycle.

It added that the starting point for projections in the report was an effective exchange rate index (ERI) of 109.4 and that this was about 4.0 percent above the central path assumed in the November report. The latest projections assume, in the central case, that sterling's ERI declines to 107.1 at the two-year forecast horizon.

"The UK economy remains on course for steady growth," the report said. "The high exchange rate means, however, that the prospect is one of continuing imbalance between domestic demand and external demand, and further pressure on the internationally exposed sectors of the economy. Interest rates will continue to be set to achieve the 2.5 percent inflation target. Inflation is at present on track to meet the target."

The report said that some members of the Monetary Policy Committee (MPC), which sets the level of interest rates, had based their inflation assessment on assumptions that were different from those in the inflation report's "fan chart" on inflation projections. The areas of particular uncertainty included the future path of the exchange rate and the degree to which technological and technical developments were likely to reduce inflation in the medium term.

"Alternative judgments on these issues led some committee members to favour inflation profiles that would be higher or lower than that shown in Chart 2 by up to 1/2 percent at the two-year forecast horizon."

The report said that labour market conditions may have tightened somewhat since the November Report. It said that survey measures of employment intentions remained firm, and reports of skilled labour shortages have become more widespread.

But the report said that annual pay growth was significantly higher than expected in November but added that the few pay awards that had been announced for 2000 were a little lower than last year. "The consequences for firms' costs of pay growth suggest that whole-economy productivity growth is recovering after several years below trend, and manufacturing has picked up sharply."

"The immediate prospect for the British economy continues to be steady growth with low inflation," said central Bank deputy governor Mervyn King, in notes for a news conference on the report.

He said that inflation had been below target recently but that rates had been increased by 100 basis points in any case. "..the aim of these pre-emptive increases by the MPC was to look ahead and keep inflation on track to meet the target. Because of the action by the MPC since last summer, interest rates will be lower than would have been the case had action been delayed."-Reuters