February 15, 2012 10:54 pm

King puts damper on economic forecast

The Bank of England’s forecast for inflation and growth suggests a more benign path for the economy than that of a few months earlier, with inflation no longer expected to be far below its target in two years’ time.

However, Sir Mervyn King, Bank governor, emphasised the downside risks to the new forecast, released on Wednesday, noting that there were headwinds that might weigh on growth. His remarks were interpreted as a sign that further gilts purchases, known as quantitative easing, were only likely if the economy deteriorated materially.

However, he noted there were offsetting factors that might boost inflation, including risks that political tensions in oil-producing nations such as Iran and Nigeria could boost oil prices. He also noted that challenges to sovereigns and banks in the eurozone remained unresolved.

“The biggest risk to recovery stems from developments in the euro area, where there remain concerns about the indebtedness and competitiveness of some member countries,” Sir Mervyn said in prepared remarks.

In its quarterly inflation report, the Bank showed its “central projection” for inflation – defined as the most likely of many possible outcomes – to be just below its 2 per cent medium-term target by the end of 2012, but not to be much further below that by the end of 2013.

On the broader economy, the Bank announced a new central projection for GDP growth to reach an above-trend 3 per cent year-on-year rate by the end of 2013. This represents a faster pace of growth than that predicted by any private-sector economist in a survey published this week by the Treasury. In part, that upbeat forecast reflects the additional £50bn in QE which was announced earlier this month. But Sir Mervyn also said an expected fall in inflation would leave households with more money to spend, boosting demand.

Michael Saunders, of Citi, is one of several economists expressing scepticism that the Bank’s growth forecast will materialise, noting that there are too many factors weighing on growth.

Simon Wells, economist at HSBC, said the main uncertainty surrounded household demand. The level of household consumption in the third quarter of 2011 is only 1 per cent above its trough in mid-2009. “If you look at indebtedness and uncertainty about employment, I don’t think demand can be that strong,” said Mr Wells.

Andrew Sentance, a former member of the Bank’s monetary policy committee and now economic adviser to PwC, said he thought the growth forecast was too optimistic.

“My main reaction to the inflation report is that it looks rather optimistic on growth. Along with previous MPC forecasts, it’s tending to overestimate growth, and underestimate inflation,” he added.

Among other assumptions, the Bank believes the gap between what the economy can produce and what it actually is producing – known as the output gap – remains wide. That implies growth could accelerate without provoking inflation because there is plenty of spare labour and capacity before companies have to compete aggressively for it.

Sir Mervyn also robustly defended the Bank’s decision to purchase only gilts in its efforts to stimulate demand, rather than private sector assets as some other central banks have done and a move that might do more to help ease credit supply to hard-pressed smaller businesses. He said buying private sector assets would amount to a subsidy from the public sector.

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