Sickly Britain crawls towards low growth

Bank offers 'unusually uncertain' picture of an economy in need of 'healing'

By Sean O'Grady, Economics Editor

Thursday, 14 May 2009

The UK faces a "relatively slow and protracted recovery", according to the Governor of the Bank of England, Mervyn King. The Bank's latest Inflation Report suggests that the British economy will contract by about 4 per cent this year, with a nadir of -4.5 per cent around the summer, before returning to growth early in 2010.

Next year is projected to see an expansion of about 1 per cent, with growth of 2.5 per cent following in 2011. These are more pessimistic forecasts than the Treasury's Budget predictions of -3.5 per cent, 1 per cent and 3.5 per cent respectively. They are also lower than the Bank's previous estimates, published in February (of -3 per cent, 2.3 per cent and 3.6 per cent).

Mr King warned that "the pace of the recovery may be slowed by a number of factors: the contraction in world demand and trade may be protracted; households may save more; and the availability of credit to companies and households may improve only gradually". He again expressed concerns about the level of bank lending, especially higher fees and other charges, and endorsed recent comments by the former chairman of the US Federal Reserve, Alan Greenspan, that the banks may still not have the capital they need to return to more normal levels of lending in today's risk-averse climate.

Even so, Mr King again repeated that the authorities had "stabilised" the banking system after the panics of the past year. Inflation, says the Bank, is likely to stay below the official 2 per cent until at least 2012 – even with the hundreds of billions of spending power now being injected into the economy. The Bank says that inflation will reach 1.5 per cent by the end of 2010.

The markets took the report as signalling a continuation of the Bank's loose monetary policy to avoid deflation or a relapse in the recovery; gilt prices firmed, inferring lower interest rates, yesterday. Sterling weakened against the euro and the dollar after Mr King's remarks. George Buckley, of Deutsche Bank, said: "These uncertainties add to our conviction that the Monetary Policy Committee will be reticent to take back policy easing quickly. To do so could threaten any continued economic improvement and potentially lead to a W-shaped (rather than V-shaped) recovery."

The expectation is that interest rates will remain at 0.5 per cent for another year, and the policy of quantitative easing completed and possibly extended even further. Jonathan Loynes, of Capital Economics, commented: "The prospect of a prolonged period of very low short rates and possible further asset purchases provides scope for a further rebound in gilts."

David Page, economist at Investec, added: "Given the uncertainties, we would not be surprised to see the BoE raise its asset purchase target again. This could include asking the Chancellor to raise the £150bn asset purchase ceiling."

However, Mr King also gave "pretty solid" reasons why the economy ought to stage a recovery. Apart from survey evidence from business organisations and the Bank's own soundings on the economy, Mr King pointed to the large fiscal and monetary stimulus now being implemented by the authorities; the near-30 per cent deprecation in sterling since its peaks in 2007; and the reversal of previous "destocking" effects – where retailers sell from stock in the face of falling sales and cancel orders from factories, something that greatly exacerbated the downturn among manufacturers in particular. Mr King said that the financial system had received "emergency treatment": "a period of healing was now required".

Throughout the report the huge countervailing forces facing the economy are stressed, leaving the outlook for economic growth "unusually uncertain". The Bank's "fan chart" to illustrate the range of outcomes it deems possible is extremely wide: a 7.5 percentage points spread compared with the 4.5 percentage points in the May 2008 Inflation Report. Mr King offered the view that "the chance that the level of output will be higher in the middle of 2010 is... no higher than the probability that output will be lower in the middle of 2010. In other words, growth has just as much chance of being positive over the next 12 months as it has of being negative".

Despite past public misgivings about the public finances, Mr King went out of his way to compliment the Chancellor, Alistair Darling: "It was helpful that the Budget was extremely honest and open about the scale of the fiscal problems facing us... There certainly seem to us at least as many reasons to suppose that it may turn out to be a smaller deficit than a bigger one." Nonetheless he was less generous on the longer term outlook: "There is no doubt that we will need to move back to a path for fiscal sustainability – that is very important."