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Bank of England in Rate Stalemate

Robin Knight,|Assistant Web Producer
Wednesday, 7 May 2008 | 9:23 AM ET

UK interest rates are expected to remain on hold at 5 percent when the Bank of England’s Monetary Policy Committee announces its decision Thursday, as fear of inflation prevents aggressive cuts that could boost Britain’s weakening economy, analysts told CNBC.com.

Rising inflation is stopping the BoE from cutting more aggressively, Amit Kara, UK economist at UBS, said.

"The fallout from the financial crisis on the real economy will become more apparent," Kara said.

Only 5 out of 65 analysts surveyed by Reuters this week expected the central bank to ease the cost of borrowing for the fourth time since December, despite signals that the UK economy is slowing down in the wake of the credit crisis.

"We are looking for four rate cuts, one every other month," Kara said, adding that the central bank does have room to ease rates as wage inflation has remained moderate.

A bigger-than-expected 0.5 percent fall in the measure of UK industrial production for March, coupled with weakening in the service sector and business confidence, has increased the chance of a rate cut, James Knightley, UK economist at ING Wholesale Banking, said in a research note.

"We continue to strongly favor a pause until June given the MPC repeated warnings on the threat from inflation and their concerns about inflation expectations," Knightley said.

Further Weakness Ahead

The real estate and retail markets have been among the hardest hit sectors in the UK since money markets started to seize up, and further weakness could still be ahead, Kara told CNBC.com.

"We are looking for house prices to fall 7.5% this year, and a total of 10%," he said, adding that after a decline of 10% prices should stabilize. “Consumption will stay weak for a prolonged period of time,” Kara added.

Since the central bank began cutting rates in December 2007, mortgage lenders have failed to pass on the advantages of falling rates to their mortgage customers, with some lenders raising rates, tightening mortgage approval criteria and withdrawing competitive mortgage offers.

The BoE has tried to counteract the effects of the credit crisis by pumping liquidity into the market through tender offers and a new scheme to allow banks with risky mortgage-backed assets to swap them for government bonds.

The tight lending conditions threaten to further stifle economic activity at a time when the price of oil and food are soaring and pilling pressure on the country’s consumers.

The weakening pound has been adding to the bank's concerns over inflation, as imported goods could rise in price for UK consumers, but the currency’s impact will only be limited, according to Kara.

UK Inflation is currently at 2.5 percent, above the bank's stated target of 2 percent. If the inflation rate continues to rise, as widely expected, BoE Governor Mervyn King will have to write a letter to the UK government to explain why.