The Bank of England today delivered a clear signal that interest rates will fall next year, despite a barrage of data suggesting inflationary pressures are building.

In its quarterly Inflation Report, the Bank predicted that consumer price inflation will be close to its 2 per cent target in two years' time – even if rates fall next year in line with City projections.

That was possible because the Bank became “markedly more pessimistic on the growth outlook” for the UK economy, predicting that consumers will tighten their belts in the wake of global financial turmoil, economists said.

However, speaking after the report's publication, Bank Governor Mervyn King suggested the Bank faces a dilemma over how to weigh an envisaged economic slowdown against burgeoning inflationary pressures.

The near-term outlook for the economy is “less benign for both inflation and growth” following this summer’s credit crunch, he said.

Mr King also cautioned on the outlook for the stock market.

“It’s very striking that despite developments we’ve seen in the last three months, equity prices are on average higher now than they were in August … There must be some downside risks there," he said.

Commenting on the report, Howard Archer, the Global Insight economist, said: “The Bank of England … is markedly more doveish and indicates that at least two interest rate cuts are likely.”

The Bank said CPI inflation is likely to rise to around 2.3 per cent by mid-2008, fuelled by rising commodity prices and a weaker pound. It then expects inflation to ease towards its 2 per cent target as economic growth slows.

The predictions are based on the markets' interest rate expectations. Interest rates are expected to fall to an average of 5.4 per cent in the middle of next year, and to 5.2 per cent in early 2009.

By the end of 2009, interest rates are expected to be about 5.1 per cent.

Earlier this month, the Bank’s Monetary Policy Committee kept interest rates on hold at 5.75 per cent.

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