UK inflation is likely to fall further and interest rate hike likely in 2016, BoE says

The Bank of England (BoE) has indicated that the first interest rate hike is likely in 2016 and expects inflation to fall further in the near term.

In its Inflation Report on Thursday, the central bank said UK inflation is expected be dragged to zero in the second and third quarters amid depressed energy prices. Consumer prices could possibly move into negative territory for one or two months, the BoE said.

The Bank noted that Brent crude oil had fallen by around 50% since mid-2014, leading to sharp decreases in petrol prices, which have hurt inflation.

However, Governor Mark Carney assured the market the UK does not need to worry about the kind of deflationary risks that are plaguing the Eurozone. He said inflation is likely to return to the Bank's 2% target within two years.

Inflation came to 0.5% in December, which meant Carney had to send a letter to Chancellor George Osborne explaining why the BoE fell well short of its target.

The letter, published alongside the Inflation Report, read: “Inflation pressures could be greater if lower oil prices were to provide greater stimulus to global and domestic growth or if slack in the economy were to be absorbed more quickly than in the central projection.

“If these risks materialise, it would be appropriate to for Bank Rate to increase more quickly than embodied in current market yields but the likelihood is that those increases would still be more gradual and limited than in previous tightening cycles.”

In its report, the Bank forecast the UK economy would grow at 2.9% this year and 2.9% next year, up from November's 2.6% estimate. The central bank expects consumers will feel the benefit of improving wages and lower petrol prices.

Carney also commented on the situation on Greece, saying that an escalation of the crisis would have an effect on the UK. However, he said it would not have as much an impact as it did in 2012 when the prospect of Greece leaving the Eurozone was at an all-time high.

Adam Chester, head of economic research and market strategy at Lloyds Bank Commercial Banking, said: “The Bank of England's latest Inflation Report provides a timely reminder that interest rates are likely to head higher over the medium term to keep potential inflation pressures at bay. For now, the prevailing weakness of inflation and heightened geopolitical uncertainty are likely to stay the MPC’s hand."

The Bank has signalled an increase in the interest rate from the record low of 0.5% in the third quarter of 2016.