The Bank of England gave a strong hint on Wednesday that it is likely to raise borrowing costs at least once more, possibly as soon as next month.
In its quarterly Inflation Report, the BoE said CPI inflation will be around the 2.0% target in two years time if rates rise as the market expects, while growth is likely to remain at its long-run average.
The BoE said markets expect the key repo rate to rise to an average of 5.7% in the third quarter of this year, remain there until the third quarter of 2008, before falling to 5.5% by the end of the two-year forecasting horizon.
The BoE said its central projection is for inflation to fall back sharply to below target, possibly to 1.8%, over the next year as lower energy prices feed through -- it currently stands at an annual 2.8%. The BoE is projecting that retail gas and electricity prices will fall by around 20% by the first quarter of 2008.
However, it said some of the impact of this fall on inflation will be offset by companies taking advantage of buoyant nominal demand to raise margins.
Further out, the BoE said inflation edges back up to settle around the target as the near-term falls in domestic energy prices drop out of the twelve-month rate.
This profile, the BoE, said is similar to the one contained in the February Inflation Report, though the trough occurs a little later, reflecting stronger upwards pressure in the near term from the higher oil price and the lower value of sterling.
Despite its gains against the dollar, the BoE said the sterling effective exchange rate index averaged 104.2% on May, 1.8% below the starting point in the February report.
If rates stay unchanged at the current 5.5%, the BoE said the central projection for inflation is higher than under market rates, even though the central bank sees inflation dipping below target in the near-term.
As usual, the BoE listed a number of uncertainties surrounding its inflation projections, including firms' pricing power, inflation expectations, energy and import costs and the degree of spare capacity in the economy.
As in February, it said there is "greater-than-usual" uncertainty over the outlook for inflation.
The BoE said it will need to monitor these risks closely over the coming months, adding that indicators of pricing pressure are particularly important for the medium-term outlook for inflation.
"In the central case, such measures are expected to fall back gradually," it said.
"If they were to remain elevated, that would be consistent with the possibility that inflation expectations had moved more persistently upwards or mark-ups were being raised more aggressively," it added.
In that case, the BoE said the nine-member Monetary Policy Committee would "be likely to view the upside risks as crystallizing".
Another key indicator is the cost of labor, the BoE said, which in the central case is expected to pick up moderately.
"If for example, wage pressures were to diminish, the Committee would be likely to view that as evidence that the upside risks had receded," the BoE said.
Overall, it said risk to inflation are balanced in the near-term but weighted to the upside in the medium-term.
It also said there is a range of views on the MPC on both the central projection and the balance of risks.
Growth Domestic Product Expectations
On growth, the BoE said it expects GDP to rise at around its long-run average between 2.7-2.8% over the coming two years.
"The central projection is for output to grow roughly in line its average rate over the past decade, slowing a little over the course of the forecast period as business investment and public spending decelerate," the BoE said.
Overall, it said the risks to growth are balanced.
If rates are left unchanged at 5.5%, the BoE said the growth profile would be stronger, averaging at, or around, 3% over the coming two years.