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23 Jan, 2008

Published: 11:02 Wednesday 23 January 2008
By: Dylan Lobo, Investment News Editor

The minutes from last month's UK interest rate meeting and last night's speech from Bank of England Governor Mervyn King have scotched hopes the Bank of England (BoE) would follow yesterday's dramatic move by the US Federal Reserve.

Eight out of the nine-strong BoE's Monetary Policy Committee (MPC) opted to keep rates at 5.5% at the meeting held from 9-10 January. David Blanchflower, who voted for a 0.25% cut, was the sole dove.

The hawkish vote hit sentiment in markets. The FTSE 100, which started the day in strong fashion was nursing a loss of around 50 points at 10.50am.

At a dinner last night hosted by the Institute of Directors and the Confederation of British Industry, King warned this year will pose economic challenges for the UK more so than at any other time since the BoE was given independence since 1997.

He said: 'The challenge to the Monetary Policy Committee's ability to navigate our way through the next year reflects two strong economic winds; one from the west and one from the east.

'The former is the credit crunch which has blown across the Atlantic, and threatens a sharp slowing in output growth. The latter is the rise in energy and food prices, reflecting continued strong growth in Asia, that, together with rising import prices, threaten to lift inflation noticeably above target in the coming months.'

King added that while central banks have the capacity to respond to the consequences of strains in the banking systems for their economies, the solution to the underlying problems does not rest with them but with the banks and financial markets themselves.

'Banks must reveal losses promptly, and, most importantly, raise new capital where necessary,' King said.

He does not believe the tighter credit condition in markets will be short lived and warned that weaker activity and lower asset prices could result in another round of losses for banks and a further tightening of credit conditions.

But it was King's comments on inflation which really quelled speculation that the MPC would follow yesterday's extreme move by the Fed, which cut rates by 0.75% in an emergency move in a desperate bid to stave off inflation.

King said: 'It is possible that inflation could rise to the level at which I would need to write an open letter of explanation, possibly more than one, to the chancellor.

'Although there is little we can do now to avoid some rise in inflation this year, the task of the Monetary Policy Committee is to ensure that it is short-lived.'

The worries over inflation were highlighted in the minutes from the MPC meeting.

The minutes said: 'The upside risks to inflation from supply-side developments had increased in each of the past two months, largely reflecting changes in food and energy prices and the exchange rate.'

It added higher food and fuel prices had contributed to higher input and output inflation. Manufacturers' input prices jumped by 1.7% in November, while output prices jumped by 0.5% to take the annual rate to 4.5%, it highest level since 1991.

The MPC also said sterling weakness could stoke inflationary pressures.

'Financial market prices suggested that there was a significant risk of further falls in sterling. If that were to crystallise, further pressures would be put on retail prices via higher import prices, the extend depending on the spread and degree of pass-through.

'Higher inflation in the short run could raise wage and price setters' inflation expectations, posing an upside risk to inflation over the medium term.'

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