British inflation should fall below the central bank's 2 per cent target in two years if interest rates stay at 5 per cent, the Bank of England said today.
The comments prompted markets to price in a rate cut by year-end.
The BoE's quarterly Inflation Report showed the CPI rate spiking close to 5 per cent before falling back dramatically as the effects of higher food and fuel prices wane and the economy grinds to a standstill over the next year.
"The next year will be a difficult one, with inflation high and broadly flat. But with monetary policy focused on its task of bringing inflation back to the target, we will come through the adjustment," BoE governor Mervyn King told a news conference.
The BoE's central forecast is for inflation to stand just below the 2 per cent target if rates move in line with the market yield curve. This assumes borrowing costs staying almost flat over the next year.
Risks to the inflation forecast are on the upside, the bank said.
Markets immediately moved in to price in a greater than even chance of a rate cut by the year-end - UK rates futures surged by up to 20 ticks across the 2008-09 strip as dealers brought forward the timing of anticipated rate cuts.
Most analysts had previously expected the BoE would wait until next year before cutting rates as inflation is currently running at a series-high of 4.4 percent, more than double the central bank's target.
"The tone is clearly dovish, with the economy now expected broadly to stagnate over the next year or so," said Jonathan Loynes at Capital Economics.
"Against that background, we stick to the view that interest rates will eventually fall very sharply once inflation pressures finally recede. Market rate expectations therefore have scope to fall much further in time."
The BoE saw GDP "broadly flat over the next year or so", before picking up quickly to a rate of around 2.4 per cent in two years. This was a lower profile than that predicted in May and the central bank said risks remained on the downside.
"The housing market is weaker and credit supply conditions are tightened by more than was assumed in May," the BoE said.
Reuters