In the UK inflation has picked up as well and is expected to rise by more than in the eurozone. But whereas the European Central Bank (ECB) will probably raise rates by 50 basis points this year, it is expected that the Bank of England (BoE) will remain on hold as the growth picture is expected to be much weaker than in the eurozone. Cost pressures in the UK have no doubt intensified dramatically in recent months, but it is envisaged that this sharply slower growth will mitigate against some of these cost pressures and thus ensures inflation returns to trend.

Most of the indicators outside of the latest retail sales release (+3.5 per cent month-on-month in May) - the purchasing managers' index (PMI)s, consumer confidence, the housing market and the problems UK banks are experiencing in raising capital - suggest the economy is relatively fragile. The BoE needs to weigh up the benefit of anchoring credibility against the possible cost of a sharper deterioration in growth than warranted and having to quickly reverse this decision.

In terms of how things may progress from here, there are two key features.

Problems in the banking sector are still strongly evident in the UK. As certain UK banks struggle to raise new equity, the impact of the credit crunch on the real economy is possibly only in its early stages. As a result, monetary policy is tightening with the central bank rate unchanged. Keeping rates on hold rather than cutting is in itself a signal of the BoE's commitment to inflation. Recently there were further mortgage rate hikes announced by a number of the key mortgage lenders. Over the coming year it is expected that mortgage refinancing will be a major issue for the UK household sector. Further significant house price declines looks likely.

Because of the issues in the mortgage market, when the BoE does wish to stimulate the economy, it will require ever more aggressive action. The market therefore still expects 100 basis points of rate cuts in 2009.

Higher commodity prices are having an extremely unpleasant effect on inflation this year, but ultimately the cost of higher oil prices will be translated into higher unemployment and reduced growth.

While it is expected that UK interest rates will be kept on hold this year, in 2009 the next move is expected to be down. Credibility is of major importance for a central bank in an open economy like the UK. So it is worth considering what could alter the outlook and cause the BoE to raise interest rates. There are four scenarios which could prompt such a response.

• The economy does not slow sharply. A key part of this outlook is that although headline inflation rises sharply above target, a marked deterioration in growth makes clear to price and wage setters the reason that the BoE is not raising interest rates. Thus credibility is not damaged, despite such a pronounced rise in headline inflation. Note that analysts are predicting that growth will be significantly below trend and weaker than in the eurozone.

• Sharply slowing GDP is not enough to bring inflation under control. It may be that regardless of the weakness in growth, long-term inflation expectations rise anyway. In other words, the external pressures are so severe that a deep domestic slowdown is no longer sufficient to bring inflation back to target. Tracking this risk is difficult for two reasons. First, it is not clear what level of headline inflation could prove a trigger. Could it be 4 per cent? 5 per cent? Second, long-term inflation expectations will be influenced by factors such as media coverage. At this stage in time it is difficult to know whether the focus will be growth, perhaps due to the housing market, or inflation. Third, there are few measures by which "credibility" can be tracked since many measures of inflation expectations are strongly affected by current inflation. The last set of Monetary Policy Council minutes point to nominal forward interest rates five to 10 years ahead which have been relatively stable as yet but need to be monitored carefully.

• Wage growth starts to pick up or union militancy resurges. This issue is closely tied to these first two issues. Considering the present economic situation a weaker labour force and fears of unemployment keep growth benign. But the more the cost of living rises, the bigger the risk that labour militancy returns. Perhaps this is an increasing risk, given that support for the Labour government is ailing according to recent opinion polls. This is probably not a very near-term risk because most wage negotiations happen in the first half of the year, but one has to watch carefully for rumblings of discontent in the labour market.

• A further leg down in the currency. Having welcomed the sharp fall in sterling earlier in the year, such rampant commodity price inflation may make the BoE question whether the desire to "rebalance" the economy should be put on hold as inflation concerns dominate. It might also be concerned that the decline in sterling reflects a dent to its credibility.

• This report was compiled by the marketing department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.

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