The Bank of England raised expectations on Wednesday of an interest rate cut possibly before the year-end as it forecast inflation falling below target in two years as the economy grinds to a standstill. The market reaction was swift and sharp.
Interest rate futures leapt more than 20 ticks and the pound fell more than two cents against the dollar as investors bet that borrowing costs would fall by the end of the year.
The central bank's new quarterly forecasts showed inflation - already running at more than double the 2 percent target - would spike close to 5 percent this year. But thereafter, it would fall dramatically as the effect of rising food and fuel prices wane and economic growth came to a halt.
"It may still - just - be summer, but there is a feeling of chill in the economic air," Governor Mervyn King said at a news conference after publication of the Inflation Report.
"The next year will be a difficult one, with inflation high and output broadly flat. But with monetary policy focused on its task of bringing inflation back to the target we will come through that adjustment." Fears have been growing that Britain could soon enter its first recession since the early 1990s as house prices slump and consumers cut back on spending because rising household bills are making it harder for them to make ends meet.
Figures out earlier on Wednesday showed the number of people on jobless benefit rose by 20,100 in July, the biggest jump since 1992. The jobless total, on the internationally comparable ILO measure, rose by 60,000 in the three months to June. "While we believe that the August Inflation Report has opened the door to future interest rate cuts by setting out an implicit easing bias, we do not expect a move from the BoE any time soon," said Matthew Sharratt, economist at Bank of America.
King said the road ahead would be "painful" but interest rate markets took heart from the BoE expecting inflation to undershoot the target in two years - the usual horizon it takes for monetary policy changes to affect the economy. "The August Inflation Report is consistent with a resumption of the interest rate cutting cycle before the end of the year," said Peter Newland, economist at Lehman Brothers.
Minutes of last week's meeting when interest rates were held at 5 percent for the fourth month running will not be available for another week but analysts will be focused on whether anyone will have joined MPC member David Blanchflower's call for lower rates.
"We had expected the first rate cut to come in Q1 and the risk was a pre-Christmas cut. We now think the risk scenario is the base case and the first cut comes in November," said Alan Clarke, economist at BNP Paribas. Some economists, however, said it would be difficult for the BoE to cut rates when inflation was so high.