LONDON (MNI), May 11 – The Bank of England’s May Inflation Report
fully justifies a rate hike in the second half of this year, leaving the
debate over the precise timing.

The Inflation Report projections leave the question hanging over
whether the first 25 basis point hike will come in August or November.
The one caveat, however, is that events have a habit of overtaking
the Inflation Report forecasts, and if there is another raft of weak
economic data in coming months, the hike could be pushed back yet again.

The central projections in the Inflation Report convey an
unambiguous message. Inflation will come in very close to the 2% target
set for the BOE’s Monetary Policy Committee if there is a hike later
this year.

Based on market rate assumptions the MPC best collective view “is
that the chances of inflation being either above or below the 2% target
are roughly equal.”

The ribbon chart showing the probability of inflation being above
the 2.0% target at both the two and three year forecast horizons shows
the probability of it being over 2% is clearly higher than was assumed
in the February Inflation Report – and a shade over 50%.

The modal, most likely projection shows a clear worsening in the
near term inflation outlook. CPI fell back to 4.0% in March from 4.4% in
February, but the Inflation Report predicts the decline will prove to be
short lived.

“There is a good chance that inflation will reach 5% later this
year and it is more likely than not to remain above the 2% target
throughout 2012,” the report says.

The average, quarterly CPI peak is put at around 4.8% in the third
quarter of this year, compared with the 4.5% peak in the previous
quarterly Inflation Report from February.

The February Inflation Report showed CPI dropping below 2% in both
Q3 and Q4 2012.

In the May report, on the modal, market rate projection CPI
eventually falls back to just a shade 2% two years ahead, and then stays

That modal forecast is based on interest rate assumptions, derived
from 15-day market rates, that Bank Rate rises to 0.7% in Q3 and 0.8% in
Q4. Markets had pushed back their rate hike expectations compared to the
15 day average, and were not fully pricing in a 25 basis point hike
until early 2012.

In the wake of the publication of the Inflation Report projections,
markets did a quick rethink. A 25 basis point hike is now fully priced
in by December, with a just over 90% chance of this hike by November and
just over 40% by August.

The caveat is that we have been here before. The BOE February
Inflation Report’s projections were broadly comaptible with a May hike
in Bank Rate, but it never materialized and as the soft activity data
came through in the weeks and months after the February report, markets
priced out a May move.

BOE Governor Mervyn King, asked about the implications of the May
Inflation Report for Bank Rate, left the timing of the first hike open.

“Bank Rate can’t stay at this level indefinitely, I’m very happy to
confirm that and to say that at some point Bank Rate will undoubtedly
need to return to more normal levels. I don’t think that tells you
precisely which month… it’s something we explore every month,” he

The divisions among MPC members add to the uncertainty on the
outlook. Arch hawk Andrew Sentance, who has been voting for an immediate
50 basis point hike, has attended his last MPC meeting.

His successor, Ben Broadbent’s view, are open to doubt. BOE Deputy
Governor Charles Bean has been the one who has most clearly set out the
case for a wait-and-see policy, until it is clear whether the current
weakness in acitivity is just a soft patch, or something more.

The Inflation Report itself makes grim reading for the UK economy.
The combination of a cut in the growth forecasts and the rise in the
inflation forecasts suggests an economy that, as analysts note, has been
hit by a supply side shock.

“We have changed our view of the long-run sustainable growth rate,”
King said.

Nevertheless, the MPC’s central view is that the non-existent
growth shown in combined official fourth quarter and first quarter
growth figures will prove to be a temporary setback, with the data
distorted by the Office for National Statistics highly questionable
construction output numbers.

“Looking ahead the judgement is that the weakness in output
over the past two quarters is a temporary phenomenon, partly supported
by the view that in the first quarter, at least, the first estimate of
the ONS did have clear signs of pick up in manufacturing and service
sector growth, the weakness came from construction,” King said.

If growth does pick up markedly in Q2 and Q3, and CPI moves as
expected up towards 5%, then the long, long awaited hike in Bank Rate
will finally materialize.

–London newsroom 0044 20 7862 7491; email:

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