British inflation will fall below its 2 per cent target even if interest rates stay at their record low and the new government does not put in place extra fiscal tightening, Bank of England forecasts showed today.
BoE governor Meryvn King welcomed plans by Britain's new Conservative/Liberal Democrat coalition to make extra budget cuts this year, saying the past two weeks of euro zone financial tumoil had increased the urgency for fiscal consolidation.
"The financial crisis is far from over," Mr King said in a news conference after the publication of the central bank's quarterly Inflation Report. "The banking crisis has turned into a potential sovereign debt crisis."
The BoE said in its report that downside risks to economic growth in the near term had increased and that the pace of recovery remained uncertain, and indicated that interest rates may stay low for longer than markets expect.
"What is clear is that the bank anticipates a vigorous fiscal retrenchment and will closely monitor its impact on the economy. We therefore do not expect monetary tightening to commence this year," said Hetal Mehta, economic advisor to the Ernst & Young ITEM Club.
Gilt futures rose and sterling fell after the BoE Inflation Report was published, as they boosted market expectations that it would be a long time before the Bank of England raises rates, and gilts extended gains when King said he could not rule out more quantitative easing.
The central bank pumped £200 billion of new money into the system to help drag Britain out of its deepest downturn in its post-War history but halted that programme earlier this year.
The new BoE projections show inflation at around 1.4 per cent in two years time if interest rates rise as markets expect, and just below 2 per cent if they are kept steady at 0.5 per cent.
Both these estimates are based on former finance minister Alistair Darling's budget plans, which the newly elected Conservative/Liberal Democrat government has pledged to toughen.
In a clear warning to new finance minister George Osborne not to shirk difficult budget choices, Mr King said that while there were major differences between the UK and countries like Greece, there was no time to lose in bringing down the budget deficit.
"It is imperative that our own fiscal problems are dealt with sooner rather than later," he said.
The latest inflation projections are slightly higher in the near term than those made in February, and suggest that inflation will remain above target for the rest of the year, which could push up public inflation expectations.
But inflation is then seen falling below target, where it remains for most of the three-year forecast period. The BoE noted that there was a high level of uncertainty because of a lack of clarity on the pace of the recovery and the amount of spare capacity weighing down on prices.
Chief among the growth worries were market jitters over countries' budget deficits, uncertainty of the effects of the BoE's quantitative easing and past falls in sterling.
Reuters