Inflation will likely overshoot the Bank of England's 2 per cent target if its cuts interest rates as aggressively as markets now expect, the central bank said today.
But the BoE's quarterly inflation report still left the door open for at least one more cut in borrowing costs as inflation was seen falling short of 2 per cent if rates were held at their current 5.25 per cent.
Financial markets have been betting the BoE will follow up last week's quarter-point cut in interest rates with three more reductions by the end of the year to shore up an economy buffeted by the global credit crunch.
But the BoE forecasts suggest that market expectations of aggressive monetary easing may be overdone, particularly as inflation is seen rising to 3 per cent by the middle of this year - just shy of the level which would force Governor Mervyn King to write an explanatory letter to the government.
Sterling promptly rose after the report as the market scaled back expectations of further cuts.
The BoE predicted that growth would slow sharply, to a rate of below 2 per cent by the end of 2008 from roughly 3 per cent now, before recovering to around 2.5 per cent at the end of its two-year forecast period.
Risks to the growth forecast were on the downside and those to inflation were balanced.
"Both developments are now more acute than in November and a result the near-term oulook is one of inflation rising sharply alongside a marked slowing in growth," Bank of England Governor Mervyn King said at a news conference.
There was also much discussion in the inflation report of the recent fall in sterling - 6.1 per cent below its level at the last Inflation Report in November.
One cause for the decline, the report argued, might be Britain's large current account deficit, the largest as a percentage of GDP in the Group of Seven industrialised nations.
"The Monetary Policy Committee attaches weight to the possibility that much of the fall in sterling reflects a more persistent decline in the real exchange rate, consistent with a rebalancing in growth away from domestic demand and towards net trade," the report said.