Markets may have got it all wrong on UK rate hikes

By Sumeet Desai - analysis

LONDON (Reuters) - Panicked by rising inflation, financial markets are betting the Bank of England will raise interest rates several times this year, but a slowing economy means the central bank's next move is more likely to be down.

After months of worrying about little more than a credit crunch-sparked global recession to rival the 1930s, investors now seem fixated with the prospect of a return of 1970s-style inflation as oil and food prices reach for the skies.

European Central Bank President Jean-Claude Trichet warned last week that euro zone interest rates may have to rise in July to curb inflation and Federal Reserve Chairman Ben Bernanke's tough talk has also raised the prospect of a U.S. rate hike.

Spooked by nightmare UK inflation numbers on Monday, 2-year swap rates in Britain jumped 30 basis points, the biggest rise since Black Wednesday September 16, 1992 when the then-Conservative government said it would jack up official rates to 15 percent.

Yields on two-year gilts have risen by nearly two percentage points since March and markets are betting on as many as three rate hikes ahead.

But rate rises don't seem likely even if inflation is already at 3 percent, a full point above the central bank's target, and expected to go higher still, because the economy is slowing and fears are growing of a housing market crash.

"Weakening economic activity is likely to help restrain second round effects from surging energy and food prices, preventing the need for the BoE to tighten monetary policy in coming months as the market currently expects," said Matthew Sharratt, an economist at Bank of America.

"(But) while we still believe that there is a slightly better-than-even chance that the BoE could resume easing late this year, the overwhelming risk is that, if oil prices remain at current levels, any monetary easing would be delayed into next year."

HOUSING MARKET CRASH?

It was only a few weeks ago that most analysts had thought the BoE would cut rates this month. Inflation hitting 3 percent in April was the shocker for both policymakers and pundits, kick-starting expectations the next move will be a hike.

"The recent shift in market expectations for UK interest rates has been nothing short of dramatic," said Jonathan Loynes, chief European economist at Capital Economics. "We continue to expect rates to fall to around 3.5 percent next year."

People thought the BoE could not possibly countenance cutting rates when inflation was so far above the target. If it rises any further, Governor Mervyn King will have to write to the government explaining what he plans to do about it.

But King is also well aware of the risks to the economy if rates do go higher. The financial crisis is not over yet, he warned on Tuesday.

And consider his comments in April, when he predicted inflation would rise to 3 percent or more: "The Committee have judged that it would not be sensible to raise interest rates significantly at this stage in order to induce a recession to try and keep inflation below 3 percent."

BoE policymakers will have noted that the interest rates people pay have already gone up without them lifting a finger because of the change in rate expectations -- many mortgage lenders have raised the cost of their fixed-rate mortgages.