• Aug. 16, 2017, 12:18 pm

Bank of England will look past election to inflation risks ahead

By David Milliken

LONDON (Reuters) – While Britain’s politicians are likely to be struggling to form a government next week, the Bank of England will look further ahead and consider whether markets are too relaxed about the prospect of higher interest rates.

The BoE is expected to keep rates at a record-low 0.5 percent — their level for more than six years — at its monthly meeting on Monday, according to every economist polled by Reuters this week.

But on Wednesday, BoE Governor Mark Carney may expand on a recent observation by the Bank that financial markets expected only an “exceptionally slow” pace of interest rate rises. That caused investors to bring forward their rate hike expectations.

Britain’s election on Thursday looks unlikely to give one party a majority, and a government may not be in place by the time Carney presents a quarterly update of the BoE’s forecasts. In any case, it will be too soon for the BoE to reach a view on how any new economic policies might affect growth.

“I think they’ll be very guarded,” said Ross Walker, an economist at Royal Bank of Scotland. “I don’t think they’ll stand up and say there’s a percentage point knocked off GDP as (Labour leader) Ed Miliband has walked into Downing Street.”

Indeed, if Labour were to slow the spending cuts planned by the previous Conservative-led coalition, that could bring higher rates, former BoE Deputy Governor John Gieve said.

“If you’re betting on interest rates going up, then they’re likely to rise earlier under a Labour-led coalition that will have a more expansionary … fiscal policy,” he said at a discussion with economists at Fathom Consulting on Wednesday.

Talk of rate rises may sound premature after the latest economic data. Britain’s economic growth halved in the first quarter of 2015, and the BoE has said it expects inflation to fall below zero in the coming months.

However, the BoE focuses on where inflation is likely to be in two years’ time, and prices could pick up if growth accelerates in the euro zone, oil prices rise and Britain’s weak productivity fails to improve.

Expectations in markets that interest rates will rise only slowly may prompt the BoE to raise its forecast for inflation in two years’ time. In February, it said inflation in two years’ time was likely to be just below its 2 percent target.

In April, markets were pricing in no rate move until September 2016 and for rates to rise slowly after that. Now, markets expect a rise in around a year’s time. Economists think a move may come slightly earlier.

Markets have been repeatedly wrongfooted by the BoE. Almost a year ago, it warned that they were underestimating the chance of a rate rise, causing a jump in sterling. Then oil prices tumbled, reducing pressure to fight off inflation.

Weak economic growth in Britain of just 0.3 percent in the first three months of 2015 has increased the chance that the BoE will trim its forecast for 2.9 percent growth this year but is less likely to hurt its identical growth forecast for 2016.

Economists also think the BoE may cut its forecast for annual wage growth of 3.5 percent late this year, after wage rises remained tepid in the early part of 2015.

(Additional reporting by Andy Bruce; Editing by Larry King)

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