King warns of threats to UK growth

King warns of threats to UK growth

By Chris Giles, Economics Editor

Published: February 13 2008 12:57 | Last updated: February 13 2008 21:07

Mervyn King’s message was uncompromising. Tighter credit conditions “will bear down on demand”, while rising energy, food and import prices “will push up on inflation”.

“Both developments are now more acute than in November,” said the Bank of England governor on Wednesday.

The Bank projects a slowdown “deeper and more persistent than in the November report”, according to its quarterly Inflation Report. Its central forecast appears to be for economic growth only a little above zero in the first two quarters of 2008, with a high probability that the economy will contract in at least one quarter.

Mr King conceded as much when he said such an outcome would not be so bad, although he cautioned against using the word “recession”.

“There is a world of difference between two quarters where the growth is minus 0.1 per cent, which is perfectly consistent with something not very far off our central projection, and six quarters of minus half a per cent or minus a quarter of a per cent, which would be much more serious,” he said.

However, it was the first time since independence in 1997 that the Bank had published such a weak near-term growth forecast.

Charlie Bean, the Bank’s chief economist, said the main reasons the Bank had cut its near-term growth forecast stemmed from an expectation that consumers would sharply rein back expenditure this year. Weaker spending alongside lower than expected investment and some weaker demand from abroad would outweigh the stimulus coming from lower sterling, which should help exporters, he added.

The report makes clear that the real fear haunting the Bank’s monetary policy committee is that weaker growth will undermine asset prices, putting further pressure on banks and prompting a further tightening in credit conditions.

This is what it calls an “adverse feedback loop”, and although not part of its central forecast the Bank cautions that “such episodes have been associated with prolonged periods of slow growth”.

Mr King said it was “more likely than not” that he would have to write to the chancellor to explain why inflation had risen more than 1 percentage point above the Bank’s 2 per cent target this year. The governor is obliged to write such a letter if inflation rises or falls by more than 1 percentage point from its stated target.

Mr King was clear that the MPC could do nothing about such price rises, which he believes will result in “a genuine reduction in our standard of living”. “There is no point in us going mad and pretending it is sensible to double interest rates in order to bring [inflation] back [to target] in the next six months,” he said.

Instead, the MPC hopes the slow growth over the coming year will “reduce pressures on capacity” and bring inflation back down close to target towards the beginning of 2009.

The message on monetary policy was that if interest rates were left at 5.25 per cent, inflation was likely to fall too far in two years’ time, but if rates were cut by almost 1 percentage point to 4.25 per cent as the money markets have been expecting, inflation would not fall sufficiently.

Economists said the Bank’s report therefore implied roughly two more rate cuts this year, bringing interest rates down to 4.75 per cent.

Economists were persuaded and most now expect only two interest rate cuts by next March. But the money markets cast the report aside, and by the end of the day the short sterling market was expecting slightly lower interest rates at the end of the year than before the report.

Simon Hayes, of Barclays Capital, said: “The MPC thinks it ‘unlikely’ that a malignant feedback loop ... will develop; ... financial market investors attach a much greater probability to this scenario.”