Britain's economy may not be slowing as much as feared after surveys on Tuesday showed a resilient services sector and housing market, reducing expectations interest rates are set to tumble.
The Bank of England is expected to lower borrowing costs on Thursday to help shore up growth, but economists believe rising inflationary pressures and signs of power lingering in the economy have muddied the outlook. "Activity is clearly not collapsing yet," said Vicky Redwood, UK Economist at Capital Economics. "While we expect interest rates eventually to have to fall quite far, they are likely to do so at a fairly measured pace."
Growth in the services sector - which makes up about three-quarters of the economy - picked up slightly in January, confounding forecasts for a deceleration. Activity in the sector has slowed considerably since hitting a near-decade high in December 2006 but there have now been two months of accelerating growth, despite a global credit crunch, which has rattled the financial services sector.
Price pressures in the sector are also mounting with input price inflation near record levels - more than enough to worry policymakers at the Bank of England. "Pricing pressures remain intense, and are a significant constraint on the ability of the Monetary Policy Committee to respond to soft activity with lower rates," said Malcolm Barr, an economist at J.P. Morgan.
Prime Minister Gordon Brown is banking on a soft landing for the economy to repair his government's tarnished reputation for financial stability before he faces a national election in 2010 at the latest. Governor Mervyn King has said the BoE is facing its toughest monetary policy challenge this year since becoming independent from government in 1997 with an ugly combindation of a weakening economy and growing inflationary pressures.
The US Federal Reserve has taken a drastic approach to staving off a recession, slashing interest rates by 125 basis points in little more than a week this year, but there is no sign of anything similar in Britain.
Some interest cuts are more than likely needed to stave off a harsh slowdown, but hawks on the Monetary Policy Committee - who wanted the economy to calm down - have made it clear too many cuts could send prices spiralling beyond their control.
Unless the economy starts to nosedive, the MPC will likely cut gently while hoping tough talk on inflation will keep record high inflation expectations from becoming entrenched.
Given wide concerns over the housing market, the MPC will take some comfort from Britain's biggest mortgage lender Halifax reporting some stabilisation in house prices in January. "While house prices are cooling significantly, they are currently not plunging through the floor," said Howard Archer, an economist at Global Insight. Many analysts are now factoring in about a five percent fall in house prices this year.
With a rate cut to 5.25 percent from 5.5 percent seen as a done deal on Thursday, the accompanying central bank statement may tell markets how seriously policymakers regard the threat from inflation and how many rate cuts may lie ahead.