Rate cuts forecast on King view inflation is peaking

Interest rates will be slashed to 3.5% from 5%, City economists forecast today, as the Governor of the Bank of England said inflation should fall next year amid fears of a stalling economy.

The Consumer Prices Index — the headline rate of inflation — was revealed to have come in at 4.7% for August, up from 4.4% in the previous month and worse than most forecasters had been predicting.

The rise prompted a third letter in 18 months from Mervyn King to the Chancellor of the Exchequer, in which he explained that energy and food prices, and the falling value of the pound, have more than doubled inflation since last December's rate of 2.1%.

King said inflation is now likely to peak higher than expected at 5%, but that the cost of living will come back below the Bank's target of 3% or less next year as inflationary pressures ebb and the economy weakens.

A marked drop in inflation will open the floodgates to repeated interest-rate cuts by the Bank's monetary policy committee, said economists. "We expect rates to come down to 3.5% next year amidst extended very weak economic activity and rising unemployment," said Howard Archer of consultants Global Insight.

Jonathan Loynes of Capital Economics said: "While the MPC's inflation concerns are not about to evaporate altogether, they are soon likely to be outweighed by worries about the length and depth of the downturn. We think there is a good chance that interest rates will start to fall, perhaps in November, before dropping all the way to 3.5% or less next year."

James Knightley of ING Financial Markets also believes rates will be cut by 1.5 percentage points, but added: "It would take some severe financial market problems or major downward revision to the activity outlook to get the Bank to move interest rates in October or even November."

However, Ross Walker of the Royal Bank of Scotland cautioned that the extent of the rise in inflation may yet stay the hand of the Bank. He said that the CPI statistics reveal rising core inflation — stripping out energy and food costs — and that future inflation figures will be swelled by the recent major increases of up to 25% in houshold utility bills.