LAST week’s Quarterly Inflation Report, published by the Bank of England, produced grim reading on the outlook for the UK economy, with two main themes emerging, of lower growth and higher inflation than was previously forecast.

According to some commentators, the UK is unlikely to see an interest rate rise for many months.

The argument put forward is that high inflation in the UK is mainly caused by sharply rising energy (especially oil), food and commodity prices. Rising UK interest rates would have no effect on these globally-determined prices.

In fact, higher interest rates would have a negative impact on the domestic UK economy, dampening growth as activity attempts to recover from the financial crisis and subsequent recession of 2008-09.

In addition, the cuts in government spending have yet to be implemented in earnest and consumers are apprehensive about spending at a time when their real incomes are being squeezed.

Large-scale unemployment, at 7.8% of the labour force, should ensure that wage growth is contained. As a result, it is inevitable that the Monetary Policy Committee (MPC) will look through the strong inflation data and leave interest rates unchanged until the long-term outlook for inflation is more assured.

However, last week’s Inflation Report doesn’t appear to agree with the above conclusion.

Economic growth estimates for the UK economy have been downgraded from 2.8% to 2.4% for 2011, 3.1% to 2.5% for 2012, and 3.1% to 2.75% for 2013 and beyond. And these forecasts are still probably too high. It seems unlikely that, over the long term, the UK economy will be able to grow at the level it achieved prior to the financial crisis, given the lower level of credit available from banks and workers choosing to permanently leave the labour market.

Despite the lower growth figures, inflation is predicted to be higher than previously expected. Inflation may now peak at 5% in the fourth quarter of 2011, and the Bank of England does not expect inflation to return to its 2% target until the summer of 2013.

Crucially, the inflation forecast is based on interest rate rises expected by the market. At the time of the report, the market was predicting one quarter point rise before the end of the year (probably in August or November), followed by further 0.25% increases every quarter in 2012.

This would raise the UK base rate from 0.5% currently to 1.75% at the end of 2012. This analysis points to one interest rate increase before the end of this year.

For many in the UK and particularly those with mortgages, the prospect of higher interest rates is daunting. However, it is important for the integrity of the UK’s financial system that the Bank of England retains its focus on targeting an inflation level of 2%.

If confidence in the Bank’s ability to control inflation is lost by consumers and investment markets, not only could the cost of borrowing for the government increase markedly but workers’ demands for higher wages could grow.

Higher wage costs are one of the greatest fears of central bankers, and if these pressures were to materialise they could eventually lead to much higher interest rates over the medium term.

Darren Ruane,

Senior Bond Strategist,

Rensburg Sheppards