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Interest rates to stay low as King predicts inflation spike

Inflation is set to spike sharply over the coming months according to Bank of England governor Mervyn King.

The forecast points to interest rates staying down at 0.5 per cent until at least the latter months of 2010.

Giving today’s inflation report, King said inflation is to rise above the government’s 2 per cent target in the near-term. This, he said, reflects higher petrol price inflation and the reversal of last year’s temporary reduction in value added tax.

The depreciation of sterling also continues to push up on inflation, according to the report.

King said inflation has been “unusually volatile” recently. In September, Consumer Price Index (CPI) inflation fell to 1.1 per cent, having been 5.2 per cent only a year ago. “Such volatility is likely to continue in the short-term,” said King. “Monetary policy can do very little to affect these short-run movements in inflation,” he adds.

The extent to which CPI inflation deviates from the 2 per cent target is highly uncertain and depends on a number of factors, says the report.

These include the timing and strength of the recovery, the impact of the downturn on the supply capacity of the economy and the sensitivity of inflation to the degree of economic slack.

However, after rising sharply in the near-term, the MPC claims inflation is likely to fall back to below the target, as the impact of the past depreciation of sterling fades and the margin of spare capacity pushes down on CPI inflation.

Insight chief UK and European economist Howard Archer says: “The Bank of England’s inflation forecasts certainly point to interest rates staying down at 0.5 per cent until at least the latter months of 2010.

“Substantial excess capacity is the key factor seen limiting inflation over the policy horizon, reflecting the sharp overall drop in GDP that has occurred during the recession, and anticipated relatively gradual recovery. Further quantitative easing cannot be ruled out, but is unlikely unless the economy suffers a major relapse in 2010.”

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