Bank of England sees slow recovery and high inflation

LONDON Wed Feb 13, 2013 12:19pm EST

Customers shop for groceries in a supermarket in London October 18, 2011. REUTERS/Neil Hall

Customers shop for groceries in a supermarket in London October 18, 2011.

Credit: Reuters/Neil Hall

LONDON (Reuters) - Britain's economic recovery will prove slow, high inflation will take longer to fall, and the central bank can do little on its own to improve matters, Bank of England governor Mervyn King said on Wednesday.

Presenting the central bank's quarterly forecasts, King gave a gloomier outlook than just three months ago. Worsening inflation in particular points to a further fall in Britons' real wages, which have just hit their lowest since 2003.

"This hasn't been a normal recession, and it won't be a normal recovery," King told reporters.

Britain's recovery from the financial crisis will continue to be slower than most of its peers, and inflation is now likely to remain above the bank's 2 percent target until 2016 - 18 months longer than expected in November, the forecasts showed.

Before the financial crisis, that would have been a signal the central bank would soon raise interest rates, but the governor made clear tighter policy was nowhere on its agenda.

King said high inflation was due to a weaker currency and government-ordered price hikes, not overly-loose monetary policy, and that the central bank should look through the effect of those factors on prices.

This is an approach that is likely to continue to find favor after King steps down in June and is succeeded by current Bank of Canada Governor Mark Carney, who has also championed a "flexible" approach to inflation targeting.

But it does not mean the central bank is about to add to the 375 billion pounds ($587 billion) of bonds it purchased between March 2009 and October 2012. It currently holds just over a third of conventional gilts.

King said this policy - also known as quantitative easing - faces diminishing returns.

"There are limits to what can be achieved via general monetary stimulus - in any form - on its own," he said. "In terms of its impact on growth, further monetary stimulus of a general kind is like running up an ever-steeper hill."

BONDS FALL

British government bonds fell sharply on King's comments and the darker inflation outlook, pushing up yields on 10-year paper, and thus likely borrowing costs, to a 10-month high of more than 2.24 percent, .

"Inflation only reaches target three years out, but the (central bank) is quite clear it will not be adjusting the policy stance to bring it about quicker," said David Tinsley, an economist at BNP Paribas.

According to the new forecasts, Britain is set for a "slow but sustained recovery" over the next three years, with output unlikely to surpass its pre-financial crisis peak until 2015.

Inflation is expected to peak at around 3.2 percent in the third quarter of this year, and then fall slowly to reach 2.3 percent in two years' time, up sharply from the 1.8 percent forecast in November.

But King said the bank would not risk undermining the slow recovery of the British economy by turning the screws on policy to bring inflation back into line.

"Attempting to bring inflation back to target sooner would risk derailing the recovery and undershooting the target in the medium term," he said.

While the bank expects Britain to avoid slipping into a 'triple dip' recession, growth will rise sluggishly to average around 1.9 percent a year by the first quarter of 2015 - marginally worse than forecast in November.

King said stronger growth would only be possible if Britain's government - already implementing unpopular austerity measures - showed greater appetite for structural reform.

Stronger overseas demand for British goods was also necessary, he added.

INFLATION TOLERANCE

Since the financial crisis, Bank of England inflation reports have often brought upward revisions to inflation forecasts and downward revisions to growth.

Inflation has not been below 2 percent since December 2009, and the bank often disregards short-term shocks to prices.

Wednesday's report suggests it is taking an even longer-term approach to getting inflation back down, and is prepared to look through several years of higher university tuition fees and government-controlled energy infrastructure charges.

This upset some in the financial markets, and sterling fell along with government bond prices, sinking to a 15-month low on a trade-weighted basis.

"Market confidence in the pound was already thin. The governor's admission that the inflation target is to be quietly ignored while the economy remains in intensive care has stretched it even further," said Jason Conibear, trading director at Cambridge Mercantile.

BNP Paribas economist David Tinsley said that in effect, the policies Carney might bring were already being put into effect.

"At the end of the second year - the old barometer for whether or not policy should change - the latest inflation projection is well north of 2 percent. In many respects, this seems to be front-running Mr Carney's approach to 'flexible inflation targeting'," he said.

Carney last week suggested he would seek a swift review of the UK central bank's remit to focus on inflation with an emphasis on more flexibility over how fast to bring price growth back to its target level.

Economists now see a 43 percent chance of a restart to quantitative easing, according to a Reuters poll published on Wednesday. In his current job running the Bank of Canada, Carney has favored giving extended guidance on how long interest rates will stay low, something avoided in Britain.

A complementary policy which some BoE officials prefer is the bank's Funding for Lending Scheme which aims to reduce credit costs. The bank said that there was growing evidence that the FLS was helping private sector credit conditions, though it was too early to see an increase in net lending.

($1 = 0.6385 British pounds)

(Writing by William Schomberg and Jeremy Gaunt; Editing by Catherine Evans)

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