The Governor of the Bank of England, Mervyn King, today dampened hopes of a new cut in interest rates as soon as next week as he issued a renewed warning that it must take a hard line to ensure that present high levels of inflation are quelled.

But he indicated that it would be a close call, with a slowdown in the economy and the impact of the credit crunch being ranged against fears of rising inflation which is expected to hit 3 per cent.

Mr King, speaking in Jerusalem, said: “We cannot allow the economy to slow too sharply,” but again underlined the MPC’s anxiety that inflationary pressures could prove persistent and hard to eradicate.

Last week, the Governor said that the credit crunch had left the Bank’s Monetary Policy Committee more “predisposed” to cut rates.

But the Bank is fearful that present steep rises in living costs will raise households’ and businesses’ expectations of future inflation, thus stoking wage demands and price increases by companies.

Today, he again emphasised those concerns. While the MPC did not want the economy to slow excessively, he insisted that “that does not mean we can ignore the pick up in inflation that is now underway”.

“We have to gauge the extent to which high inflation in the short term will enter the expectations of those setting prices and pay,” he said. Should high inflation become entrenched in expectations, it could be “costly” to dislodge, he added.

The Governor said that the MPC could now do little about an expected further rise in inflation to as much as 3 per cent on the consumer price index overcoming months. “What is crucial is that the pick up proves to be temporary, just as the rise in inflation was last year,” he said.

“The best thing that we can do to promote economic stability is to avoid inflation, and inflation expectations, from becoming dislodged from the target in the first place.”

Combined with still robust official figures today that again indicated some continued strength in the economy, Mr King’s remarks left the City divided over whether interest rates will now fall next week, or not until May at the earliest.

Today’s economic figures showed that the services sector, the engine room of the economy, rebounded from a fall in December, to expand strongly in January, by 0.6 per cent. That left services growth in the three months to the end of January running at a still robust 0.5 per cent — although this was down from a buoyant 0.7 per cent in the final quarter of last year.

RBS Financial Markets said that the data suggested that the economy as a whole grew by 0.5 per cent in the three months to January, a little down from a three-monthly pace of 0.6 per cent throughout last autumn but still only slightly below the long-term trend rate of growth in GDP.

With Mr King having last week pointed to surprising resilience in retail activity and employment, the new figures cast further doubt over the odds on a rate cut next week.

The detail of the services data suggested that the retail sector stagnated in the three months to January, while hotels and restaurants saw output plunge by 1.4 per cent.

In January alone, the figures suggested that the financial industries saw output rise by 2.8 per cent, after a 1.5 per cent December decline, while the sector growth in the three months to January compared with the same period a year earlier was put at a heady 13.8 per cent. Economists sounded warnings over the reliability of these figures, however, which they said looked odd in the context of the credit squeeze.

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