Finance news

Bank of England Governor Mervyn King may be forced to explain to the government why he no longer has the scope to cut interest rates to stave off a recession.

Inflation probably reached 3.2 percent in May, the most since the measure's inception in 1997, the median of 39 forecasts in a Bloomberg News survey show. A rate that high requires King by law to write a letter of explanation to the Treasury. The statistics office will publish the data tomorrow at 9:30 a.m. in London.

King's challenge is to protect the bank's inflation-fighting credentials as oil and food costs rise at a record pace and economic growth stumbles. The economy is heading for its worst performance since 1992, according to forecasts released today by the Confederation of British Industry.

“People are losing faith in the Bank of England's ability to keep inflation low,'' said Michael Saunders, chief Western European economist at Citigroup Inc. in London. “That's why the idea of cutting rates is off the agenda. Central banks have this problem in common, but in the U.K. it seems particularly large.''

At 5 percent, Britain's interest rate is the highest in the Group of Seven industrialized nations. U.K. inflation is also lower, at 3 percent in April, compared with 3.9 percent in the U.S. and 3.6 percent in May for the euro region.

European Central Bank President Jean-Claude Trichet said this month that policy makers may raise the benchmark interest rate in July from the current 4 percent.

Inflation `Nervousness'

“There's quite a lot of nervousness that the Bank of England will `do an ECB' to establish credibility,'' said Citigroup's Saunders. “You can't rule out that they will accept more economic downside to control prices.''

The U.K. economy will grow 1.3 percent next year, the least since 1992, compared with a previous prediction of 1.7 percent, according to the CBI, Britain's biggest business lobby. King has said that there may be a “quarter or two of negative growth.''

“The main reason'' for lowering the forecast “is that the oil price has continued to rise strongly,'' said Richard Lambert, the CBI's director general.

Crude oil prices surged to a record above $139 a barrel on June 6 and consumer group Energywatch says gas prices for U.K. households more than doubled since 2003. With the cost of living rising, Royal Dutch Shell Plc tanker drivers went on strike on June 13 for a 13.2 percent pay increase.

Support for Prime Minister Gordon Brown's Labour Party sank to the lowest level since polling began in 1943, YouGov Plc said May 30 faxless payday loans. Seventy-three percent of people surveyed predicted their financial situation will worsen in the next year, the poll showed.

`Feeling the Pinch'

“People are feeling the pinch,'' said Peter Kellner, YouGov's president. “The government's drop has coincided precisely with the collapse in consumer confidence.''

Consumers anticipate inflation will reach 4.3 percent in the next year, the highest reading since at least 1999, the central bank reported last week, citing a May survey by GfK NOP.

“I feel angry about bills going up when I know it affects the children, when we can't afford things they want,'' Wendy Game, a 45-year-old housewife from Wales, said in an interview. “What we get doesn't cover it.''

Inflation may persist above the 2 percent target if increases in price expectations get built into higher wages, the central bank's quarterly bulletin said today. It said that higher perceptions of prices were “more than can be explained by movements in the official headline inflation measures alone.''

Bean's View

While Chief Economist Charles Bean wrote that investors' perceptions of longer-term U.K. inflation “have not increased much,'' bond yields show they are the highest in the G-7.

The U.K. 10-year breakeven rate, or the difference between yields on inflation-linked bonds and nominal bonds, surged to 4.05 percentage points June 13 from as low as 3.2 points at the beginning of March. The U.S. rate was 2.53 points last week.

King has cited higher price expectations as a constraint to lowering rates. The bank will publish minutes on June 18 showing how policy makers voted this month, when they left the benchmark interest rate unchanged.

Brown, as finance minister in 1997, designed the law requiring the bank's governor to write a letter if inflation strays more than a percentage point away from the target. That has happened only once, after it touched 3.1 percent in March 2007.

If inflation exceeds 3 percent, the bank will publish King's letter an hour after the data release. He will have to send one every three months if the rate continues to stay above that level. King predicts that will happen for “several quarters.''

“This little piece of theater draws more attention to inflation,'' said Ross Walker, an economist at Royal Bank of Scotland Group Plc in London. “If we get a rate move this year it will be a hike.''

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