Inflation forecast to fall below Bank target

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Britain’s economy is expected to grow so slowly this year and next that inflation is likely to fall below the Bank of England’s target rate much more quickly than the Bank expects, according to a leading independent think tank.

The National Institute of Economic and Social Research, issuing its regular quarterly update, downgraded its growth estimate for 2011 by a further 0.1 percentage points to 1.3 per cent, with growth in the second half flattered by the fact it was dragged down earlier in the year by the effects of an additional bank holiday and unusually low oil and gas consumption.

“Subdued domestic demand will hinder any meaningful recovery this year,” Niesr said. It said that because wage growth was falling so far behind the inflation rate, consumer spending was likely to fall by 0.8 per cent this year. In the first quarter, it contracted by 0.6 per cent compared with the fourth quarter of 2010.

Moreover, slow wage growth would not be sufficient to halt a rise in unemployment, which would increase to 8.3 per cent in 2012, from 7.7 per cent now.

However, Niesr expected inflation to average 1.9 per cent over 2012, below the Bank of England’s 2 per cent medium-term target. In its last inflation report, the Bank did not expect inflation to fall below 2 per cent until the second quarter of 2013, and only then if interest rates rose in line with market expectations.

However, because economic data have been so much weaker than expected since May, markets are not pricing in any interest rate rises until well into 2012.

Assuming rates hold steady over the forecast period at 0.5 per cent, the Bank’s forecast does not assume inflation will fall to its target level within the next two years, reaching 2.34 per cent in the second quarter of 2013.

According to Niesr, weaker consumer spending would also affect the government’s chances of hitting its targets for reducing public sector borrowing, because revenue growth would lag behind the rates pencilled in by the independent Office for Budget Responsibility in March. The OBR is likely to unveil revised economic and fiscal forecasts in November.

Niesr expects public sector borrowing to shrink by only 1 per cent of gross domestic product in 2011-12. “The chancellor will miss his primary target of balancing the cyclically adjusted current budget by 2015-16 by around 1.0 per cent of GDP,” Niesr said.

Niesr urged George Osborne, the chancellor, to hold off on any further fiscal consolidation. “Indeed, it remains our view that in the short term fiscal policy is too tight, and a modest loosening would improve prospects for output and employment, with little or no negative effect on fiscal credibility,” it said.

Angela Eagle, shadow chief secretary to the Treasury, said: “If these worrying forecasts of slower growth and higher unemployment come true then George Osborne will miss his targets to reduce government borrowing.” She added: “A plan is only credible if it delivers and the evidence is growing that George Osborne’s rash plan is not working. The cautious thing to do is to act now before it’s too late. The reckless thing to do is to plough on regardless, as this chancellor seems determined to do.”

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