The Bank of England's quarterly forecasts on Wednesday are likely to signal a deterioration in both growth and inflation prospects, suggesting future interest rate cuts will be gradual.
Bank policymakers face the tough balancing act of protecting the economy against the impact of the credit crisis at the same time as energy, food and import prices are rising – a task Governor Mervyn King has described as the most challenging in a decade.
The Bank cut interest rates last week for the second time in three months, citing weaker growth and tighter credit conditions. However, it also warned that higher food and energy costs could raise inflation "possibly quite sharply" in the near term.
Investors are betting interest rates will come down to 4.5 per cent by the end of the year – implying three more quarter-point cuts.
Many analysts, however, suspect the Bank will be reluctant to sanction such aggressive easing when inflation expectations have already hit a record high.
"The markets are still anticipating a fairly aggressive monetary easing over the next few months. But with inflationary pressures still playing on the Monetary Policy Committee's mind, we think it will tread more carefully," said Vicky Redwood at Capital Economics.
Consumer price inflation has been running above the Bank's two per cent target since October and is likely to spike even higher in the coming months as a result of higher utility bills.
Energy providers have announced double-digit rises to gas and electricity bills in recent weeks that will feed into next month's inflation data with full force. Bank Governor King has warned that inflation could again rise above three per cent, a level that would require him to write a letter of explanation to the government.
The Bank is likely to admit on Wednesday that near-term price pressures have risen relative to its November forecast, even though a slowing economy may allow inflation to escape the system over the medium-term.
It is also likely to indicate that the economy will grow less quickly than it previously expected.
"The November report pointed to GDP growth of 2.4 per cent this year, whilst the consensus is currently looking for something closer to 1.8 per cent," said Peter Dixon at Commerzbank.
"On the inflation front, look for Mr King to repeat the message that the possibility of a spike in inflation to the upper end of the one to three per cent corridor will constrain the speed with which the Bank of England cuts rates." (Reuters)
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