BoE sees inflation undershooting were rates to rise

British inflation will be well below the 2 per cent target in two years if interest rates rise in the first quarter, the Bank of England said on Wednesday, suggesting markets are pricing in rate hikes too early.

In its quarterly Inflation Report, BoE projections showed CPI inflation at around 1.4 per cent in two years' time if rates follow the path implied by market expectations rising to 0.7 per cent in Q1 2010 and going up thereafter.

But assuming interest rates stay at a record low of 0.5 per cent and the BoE reaches its £175 billion quantitative easing target, "the risks of inflation being above or below the 2 per cent target at the two year horizon are broadly balanced, albeit that the path of inflation is rising".

Sterling fell and UK gilts surged on the expectation that British interest rates were unlikely to rise in the coming months and that the Bank may even have to further expand its quantitative easing programme to get the economy growing strongly again.

The central bank surprised markets last week by extending its efforts to stimulate the economy, raising its asset-buying programme by £50bn to £175bn.

While the inflation profile was similar to that published in May, the outlook for growth was "somewhat stronger" given the extra stimulus pencilled in.

However, BoE Governor Mervyn King said the recession appeared deeper than the Monetary Policy Committee thought likely when it issued its report in May.

King said business surveys suggested that growth was more likely to resume over the next few quarters, but cautioned that any recovery could be slow and protracted.

The BoE charts show growth returning at the turn of the year and getting close to a rate of 3 per cent in two years' time.

"The stimulus should lead to a slow recovery in economic activity, but the timing and strength of that recovery remains highly uncertain," the BoE said.

King would not be drawn on talk of a double dip recession.

"I don't think it's helpful to talk in terms of a double-dip. What we're talking about is the pace of recovery. Short term indicators are indeed recovering and we shouldn't overlook that. Nevertheless, it will take a longer period of robust growth ... and we will still find ourselves in a difficult position for a long time to come," it said.