BANK of England Governor Sir Mervyn King has warned UK economic output "may shrink a little" in the current quarter after presenting updated forecasts which still show annual inflation falling below 2% by the end of a key two-year time horizon.
He painted a fairly bleak picture of the UK outlook as the Bank published its latest quarterly inflation report yesterday.
And he signalled that the Monetary Policy Committee (MPC) was open to raising the scale of its £375 billion quantitative easing programme further at some point, if such a move were required to help prevent a significant undershoot of the 2% inflation target by stimulating economic activity.
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Commenting on the short-term outlook for UK gross domestic product – which the Office for National Statistics said last month had surged by 1% in the third quarter after dropping by 0.4% in the three months to June – Sir Mervyn said: "Just as growth in Q2 was depressed by one-off factors and gave a misleadingly weak picture of the economy, so growth in Q3 has been boosted by one-off factors and gives an overly optimistic impression of the underlying trend."
He added: "Continuing the recent zig-zag pattern, output growth is likely to fall back sharply in Q4 as the boost from the Olympics in the summer is reversed. Indeed, output may shrink a little this quarter."
Sir Mervyn warned the UK faced a "rather unappealing combination of a subdued recovery with inflation remaining above target for a while".
Data from the ONS on Tuesday revealed an unexpected surge in annual UK consumer prices index inflation from 2.2% in September to 2.7% in October, fuelled by the Coalition Government's hike in maximum annual undergraduate tuition fees for new UK and European Union students in England to £9000.
While the MPC has raised its near-term consumer price projections in the new inflation report, it is still forecasting annual CPI inflation will fall back below the 2% target by the end of its chosen two-year time horizon even if UK base rates were to stay at their record low of 0.5% and QE were held at £375bn. This would appear to signal scope for further QE, or other monetary stimulus, if UK economic weakness were to persist.
The MPC projects significantly below-trend year-on-year growth in UK output throughout the next two years .
It sees the year-on-year growth rate picking up to about 2% around the start of 2014, still well below the long-term average of about 2.5%.
Sir Mervyn said that a rise of 8% in sterling's effective exchange rate over the past 15 months, including a 12% increase against the euro amid the ongoing crisis in the single currency zone, was "not a welcome development".
Such appreciation of sterling reduces UK exporters' competitiveness in overseas markets, and makes imports cheaper.
Looking ahead, Sir Mervyn said: "If that unfavourable world environment persists, and there's little sign of any change to underlying problems in the euro area, it may be unreasonable to expect anything other than a slow and protracted recovery, absent a further fall in the real exchange rate."
He highlighted his view that QE remained an effective policy tool. QE is aimed at stimulating activity by boosting money supply through the purchase of Government and corporate bonds, funded by the issuance of central bank reserves.
Sir Mervyn said: "I don't think anyone believes that QE is, in and of itself, less effective in the sense that, the more you do, the less effective it becomes."
He added: "The committee has not lost faith in asset purchases as a policy instrument, nor has it concluded that there will be no more purchases."
Sir Mervyn shrugged off criticism of the decision to transfer back to the Government the interest paid by the Government on the bonds the Bank has bought through QE. The move raised questions about the Bank's independence.
He said: "I think there is a lot of fuss about nothing with this scheme."