Inflation to surge toward 4% and growth to fall to 1%, Bank fears

Benchmark UK inflation is now forecast to climb to nearly 4% later this year by the Bank of England, and Governor Mervyn King yesterday admitted "an odd quarter or two" of economic contraction was "quite possible".

The leap since February in the inflation projections of the Bank's Monetary Policy Committee, which is charged with targeting annual consumer prices index inflation of 2%, yesterday hammered hopes of another cut in UK interest rates as early as June to mitigate the pain of a sharp economic slowdown.

A poll yesterday by Reuters showed only nine of 53 economists are now predicting a June cut. In a poll published by the news agency only two weeks ago, 45 of 60 forecast a reduction next month.

According to the central projection in the Bank of England's latest quarterly inflation report, produced under the guidance of MPC members and published yesterday, the UK's year-on-year growth rate will tumble to 1% around the end of this year.

Asked about the chance of recession in the UK at a news conference, King appeared to acknowledge the dangers facing the domestic economy.

He said: "It is quite possible that, at some point, we may get an odd quarter or two of negative growth, but recession is not the central projection at all. But, clearly, further shocks could push us in that direction (recession), but it certainly is not our central projection."

The Bank declares that the risks to its new central forecast for growth "lie to the downside", even though the projection in yesterday's inflation report is much lower than that which it made in February.

On the basis of market interest rate projections, which were pricing in a further fall in UK base rates from 5% to 4.5% by mid-2009 with either one or both of these forecast cuts anticipated this year, the Bank's latest central projection puts inflation at about 2.25% on its chosen two-year time horizon. These market interest rates are based on the 15 working days to May 7.

A separate fan chart, based on there being no further cuts in base rates from the current 5% level, puts annual CPI inflation bang on the 2% target two years out. Even on this basis, the chart has inflation heading up towards 4% later this year.

Referring to its forecast for inflation based on market interest rates, the Bank says: "Compared with the February report, the central projection implies a pick-up in inflation that is both larger and more prolonged."

The Bank also highlights its belief that the risks to its central projection for inflation now lie to the "upside". And the inflation report makes no bones about the MPC's expectation that King will have to write several letters in the near term to Chancellor Alistair Darling explaining why inflation has risen more than one percentage point above target.

Inflation surged unexpectedly to 3% in April, from 2.5% in March, official figures showed on Tuesday.

The inflation report highlights ever-greater uncertainties over the outlook and alludes to marked differences of opinion within the nine-member MPC.

Seemingly holding out some hope of further cuts in UK interest rates depending on what happens from here, the report states: "Policy must respond to the outlook for inflation in the medium term, and here there are also marked uncertainties. On the downside, a more prolonged period of subdued demand growth could open a larger margin of spare capacity, pulling down further on inflation."

However, it adds that inflation could remain above the 2% target for longer if its higher rate in the near term "begins to affect the expectations of those setting wages and prices".

And, although acknowledging both sets of risks had increased since February, the report states hawkishly: "In view of the larger and more persistent period of above-target inflation, the balance of those risks is judged to lie to the upside, particularly in the medium term."

Yesterday's inflation report highlights the deterioration in the UK housing market.

King said: "We have already seen house prices starting to fall and they are likely to fall further, but I don't think anyone can honestly know by how much."

The Bank Governor was, however, at pains to draw distinctions between the situation now and that in the early 1990s, in terms of people's ability to service mortgage debt.

He said: "What caused major problems in the early 1990s was the doubling of interest rates and a very sharp increase in unemployment. Those two things created serious difficulties for many families in being able to service debt. But neither of those things apply at present nor are they part of our central projection. They don't look very likely outcomes."

King added that it was "very important to hang on to that point".

The Governor, who described the MPC's "balancing act" as "even more challenging" than in February, emphasised the limits of what the committee could do about the economic situation.

He said: "We are travelling along a bumpy road as the economy rebalances. Monetary policy cannot, and should not, try to prevent that adjustment."

The Bank notes in the inflation report that the UK economy grew by only 0.4% in the first quarter, according to data from the Office for National Statistics, and highlights signals from its own agents and business surveys that expansion will be weaker still in the three months to June 30.

It also highlights its expectation that, with oil prices having risen by a quarter since the February inflation report and wholesale gas prices moving in line, "a further round of domestic energy price increases over the summer seems probable".

The MPC has cut UK base rates by a quarter-point three times this cycle, in December, February and April.

Economists still expect at least one more quarter-point cut by the year-end, according to the Reuters poll yesterday, although the median probability attached to this has fallen to 80% from 95% in the survey published two weeks ago.

Jonathan Loynes, chief European economist at Capital Economics, said: "The Bank of England's May inflation report suggests that the MPC will not deliver the rate cuts which the news on the economy suggests are sorely needed."

Loynes, whose Capital Economics consultancy is among the most downbeat of forecasters on growth, added: "The crucial point is that the MPC's inflation profile is based on what looks like an over-optimistic outlook for the real economy.

Admittedly, the near-term forecast for GDP (gross domestic product) growth has been revised down, with growth now troughing just above 1% compared to around 1.7% in February's report. But, thereafter, growth is expected to re-accelerate strongly to around 2.5% by the end of next year and to 3% in 2010. We are very sceptical that such a recovery will occur without much lower levels of interest rates."

He believed that, while 3%-plus inflation did not pre-clude rate cuts altogether, "there are clear presentational difficulties for the MPC in writing letters to the Chancellor whilst at the same time cutting rates anything more than very modestly".

But he warned: "The committee's inability or reluctance to cut rates further now increases the chances that the downturn in the economy will be both deep and prolonged. We are already significantly more gloomy than both the MPC and the consensus in expecting GDP growth of just 1% in 2009 but the risks of a more severe downturn - and even a full-blown recession - are increasing.

"Accordingly, we still believe that interest rates will eventually have to fall a very long way - to 3.5% or even lower - to prompt a recovery in the economy when inflation fears have finally receded."