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Deflation fears rule out early rate hikes

INFLATION is forecast to remain well below the Bank of England&rsquo;s two per cent target until at least 2011 if interest rates were to rise in line with market expectations, the Bank of England said yesterday in its quarterly Inflation Report.<br /><br />But should interest rates remain at 0.5 per cent and quantitative easing (QE) at &pound;175bn, the Bank&rsquo;s governor Mervyn King said the risks of inflation being above or below the two per cent target in two years were broadly balanced, suggesting expectations of rate hikes in early 2010 are premature.<br /><br />The need to return inflation to target was a key part of the Monetary Policy Committee&rsquo;s (MPC) decision to extend QE by &pound;50bn, King said.<br /><br />Inflation is expected to remain volatile in the near-term before rising when last year&rsquo;s VAT cut is reversed. <br /><br />But in the medium-term inflation is likely to remain low due to the depressive effect from the margin of spare capacity in the economy. Despite the Bank&rsquo;s strong growth rate forecast, this margin will only be eroded gradually, meaning the recovery will be &ldquo;slow and protracted&rdquo;.<br /><br />Citi&rsquo;s Michael Saunders said that in the MPC&rsquo;s thinking, the disinflationary effects of the massive output gap dominate potential inflationary worries from the projected economic recovery and the collapse in potential GDP growth among other factors. <br /><br />Lombard Street Research said that while the MPC is unlikely to increase QE before the November meeting, yesterday&rsquo;s dovish report pointed to a distinct possibility that the scheme will be expanded further at that time.