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Bank of England warns inflation to touch two per cent in spring – but will pick up again

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Inflation will briefly touch two per cent in the spring but remain above target in two years time, according to new forecasts from the Bank of England. 

The Bank published its latest Monetary Policy Report (MPR) today, as it kept interest rates at 5.25 per cent for the fourth meeting in a row. 

While the Bank dropped any reference to hiking rates further, it warned of the looming threat of persistent domestic inflation in a signal that rates might be kept on hold for a little longer than markets expect. 

Markets think that the Bank will start cutting rates in late spring with the Bank Rate reaching around four per cent by the end of the year. 

Andrew Bailey, governor of the Bank, said: “We need to see more evidence that inflation is set to fall all the way to the two per cent target, and stay there, before we can lower interest rates”. 

According to the Bank’s forecasts, which are based on market pricing, falling energy prices will push the headline rate of inflation to two per cent in the second quarter of this year. 

However, as the year progresses, the impact of energy prices on bringing down inflation will fade due to base effects. This will reveal the still stubborn rate of underlying inflation. 

Inflation is expected to pick back up to around 2.7 per cent by the end of this year, remaining above target until the end of 2026. 

This comes even as unemployment is projected to rise above the equilibrium rate by the end of the year. The equilibrium rate is the level of unemployment consistent with the two per cent inflation target. 

Inflation’s persistence reflects the effect of continued domestic price pressures. The Bank noted the recent progress on services inflation, which it has identified as a key gauge of domestic inflationary persistence, but warned it will fall “more slowly” than other components. 

It also drew attention to high levels of wage growth. The most recent ONS figures put wage growth at 6.5 per cent, which is too high to be consistent with the Bank’s inflation target.

“The Committee continues to expect second-round effects in domestic prices and wages to take longer to unwind than they did to emerge,” the MPC said. 

The forecasts could be seen as a sign that markets have gone too far in their expectations for interest rate cuts. Forecasts based on a constant interest rate show inflation falling to target sustainably by the beginning of 2025, before falling to one per cent at the end of 2026. 

GDP growth is expected to pick up over the forecast period, reflecting the “waning drag” from past interest rate rises. 

However, fiscal policy and the “relatively weak potential supply growth” will pull GDP growth below its historical average. 

By the end of the forecast, four-quarter GDP growth is projected to be around 1.5 per cent. 

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